(This article was co-produced with Hoya Capital Real Estate.)

It’s been a tough year for investors, to put it mildly.

In recent articles, I have presented the latest statistics for the Dow Jones, S&P 500 and Nasdaq indices. For this introduction, I’m going to take a slightly different approach. direction. As of today’s close, June 22, PortfoliosLab presents the classic Stock/Bond 60/40 portfolio as down 17.68% since the start of the year.

Foreign Stocks vs. US Stocks – A Snapshot and a Wide Angle View

In this case, foreign equities were not spared by this decline. In the chart below, take a look at the YTD results of Vanguard Total Stock Market ETF (VTI), an indicator of the broader US market and Vanguard Total International Stock ETF (NASDAQ:VXUS), a similar approximation for the total investable foreign market.

This chart is the snapshot I referred to in the title of this section. As you can see, the results are relatively similar, and none of it is good. It’s results like these that cause many investors to stay away from foreign stocks and an ETF like VXUS.

Interestingly, however, it’s not just because of the lackluster performance of foreign equities in 2022. Sophisticated investors know that US equities have outperformed their foreign counterparts for many years now, by far.

This is dramatically highlighted in this next graphic, where we step back from our snapshot and take what we might call a wide-angle view. This backtest, from Portfolio Visualizer, analyzes the total return of VXUS and VTI, including reinvestment of all dividends, from January 2012 to present. Here’s a handy link if you want to check the backtest for yourself.

As you can see, over the past 10 years or so, VXUS has been earning just over 6% per year. Over the same period, VTI returned almost 14% per year.

I have already indicated that VXUS and VTI have seen significant declines this year. Before leaving this section, note one more thing. If you look back to the start of 2020 when the market was hit hard due to the COVID-19 shocks, you will notice that owning VXUS did not provide additional drawdown protection compared to VTI. In fact, if you dig into the details of the backtest I provided, you’ll find that the Max Drawdown value of 25.54% shown for VXUS actually stretched over a period of over 2 years, from February 2018 See you March 2020!

Given all of this, here is the question of the day. Given that the US market has fallen significantly and is now well off its all-time highs, should investors bet on US equities to try to recover from this downturn? Or is there still room for foreign stocks in your portfolio? If foreign equities have clearly underperformed and, on top of that, apparently offer no additional downside protection, why should they even be considered?

Foreign Equities – Insights from a Pioneering Study

I recently wrote an article warning investors against falling victim to recency bias, which has been defined as “the unfounded belief that recent trends will continue into the near future.” In addition to my personal perspective, the article describes how foreign equities play a prominent role in, for example, Vanguard’s professionally managed target date pension funds.

However, while researching this article, I decided to try to investigate the “whys” of the recent underperformance of foreign equities relative to their US counterparts. Luckily, I came across an excellent whitepaper from Vanguard that did a sum-of-the-parts breakdown to explain the differences.

Before going any further, there is one caveat I should share. The paper, written in late 2020, looked at the 10 years ending December 31, 2019. In other words, the data is about 2.5 years old at this point. However, I could make the observation that over these two and a half years, the trend has actually intensified in favor of US equities. What do I take away from that? The case for including a foreign equity allocation is, to say the least, even stronger now.

One by one, let’s go through 4 of the very useful charts from this white paper.

In this first chart, the “delta” or the difference between the 13% return on US equities and the 5.1% return on foreign equities is broken down into components.

The first thing the article presents is that over the past 10 years, U.S. nominal GDP growth has outpaced international growth by 1.8 percentage points per year on average on a market-cap-weighted basis. .

Therefore, not only did US earnings growth of 1.5% contribute to the outperformance of US equities, but the valuation given to US equities as a result contributed to a much larger gap of 5.4 %. Additionally, over the decade in question, a strong US dollar can be seen to have contributed to a 2.1% loss in returns on international assets held by a US investor.

Interestingly, the only positive deviation in favor of foreign equities was related to dividend yield, with a 1.1% advantage. The extremely strong performance of US growth stocks, which typically pay little or no dividends, has contributed to foreign stocks earning a higher dividend payout.

Our second chart is for a fairly notable jump in profit margins in the United States over the decade 2010 – 2019.

While Vanguard notes that not all of the reasons for this are 100% clear, it offers this observation:

This increase could be caused by globalization; it occurs less than 10 years after the entry into force of the North American Free Trade Agreement (NAFTA) and corresponds both to an increase in US imports and exports as a percentage of GDP and to the inclusion of China in the World Trade Organization (WTO).

Together, the first two charts help shed light on the outperformance of US equities over this period.

However, at the time of writing this whitepaper, Vanguard did not expect this to continue. As can be seen in our 3rd chart, Vanguard projected an average annual return of just 4.7% for US equities for the decade ending December 31, 2030, while foreign equities were expected to post average annual returns of 8, 1%.

Please look carefully at the graph above. What you might find interesting is that Vanguard is still projecting US profit growth outpace that of international growth (5.0% vs. 4.3%). You can also see this value reflected in the -0.7% value (reddish-brown bar) in the chart. So it’s not that the earnings capacity of US stocks will fall off a cliff.

What then would explain the higher yields on offer for foreign equities?

In simple terms, the starting point. Vanguard suggests that higher initial valuations for US equities will be a headwind going forward.

The chart above can be a bit difficult to interpret. I will try to help. The x-axis, or horizontal line, displays the starting P/E ratio for the stocks in question; the further to the right you go, the higher the value. The y-axis, or vertical line, represents the annualized returns of the Next Period of 10 years.

The basic takeaway? The higher the starting value, the lower the returns generally are over the next 10 years.

As can be seen, the starting P/E value for US equities is much higher, or further to the right. Therefore, generating those same high returns in the future is, statistically, much more unlikely. With foreign stocks, the odds are more in your favor.

Putting it all together – and looking back even further

What did you think of the title of my article?

I borrowed the famous phrase “past performance is not indicative of future results”. Usually it has a negative connotation, doesn’t it? A sort of “buyer beware” investor caution, if you will.

But, in the case of investing, it can work in two ways. In some cases, the forward outlook may be positive. In addition to Vanguard’s whitepaper projection, is there any historical precedent to believe this could happen in the case of foreign equities?

To answer that question, take a look at a second backtest, from Portfolio Visualizer. In this case, instead of choosing ETFs as a proxy, I chose asset classes because the data is available much further afield if you come from that direction.

Here’s how it happened.

• From 1986 to 1988, foreign stocks absolutely beat US stocks.
• From 1989 to 1992, US stocks had the upper hand.
• From 1993-1994, foreign equities regained the upper hand.
• From 1995 to 2001, US stocks again beat foreign stocks, with one brief exception in 1999.
• From 2002 to 2009, foreign equities were far more often in the lead than they trailed.
• In general, US equities have since prevailed, as can be seen clearly in the widening gap between the blue and red lines in the last chart above.

Over this 36-year period, it becomes clear that while US equities have outperformed overall, there have been several occasions when the tide has swung in favor of foreign equities, and for years at a time.

That said, we return to VXUS, the ETF featured in this article.

In a nutshell, if you agree with this analysis and want to include a foreign equity allocation in your portfolio, VXUS may be your preeminent choice.

This beautiful graphic jumpsuit from here on Seeking Alpha captures it well.

VXUS gives you exposure to nearly 8,000 stocks outside of the US, across the size spectrum; small, mid and large caps. And all this at a low expense ratio of 0.07%.

I hope you found this article interesting. Feel free to share your comments, questions, and even criticisms in the comment section below.

Until next time, I wish you…

Successful investment!