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More Risk with Less Return

We are frequently asked for our opinion on international investing. Recent articles suggest an overweight allocation to international stocks, more specifically in European stocks, because of their attractive valuation relative to US domiciled stocks. While we agree the valuations may favor Europe over US in the short run, our concern is the risk/reward trade off in doing so. To summarize some of those risks:

  • Transparency: Companies abroad follow different financial reporting standards and abide by different regulatory bodies so comparing apples to apples may be difficult. Less transparency can mean more volatility because audited financial information may not be provided on a regular basis and the local markets may be less liquid.
  • Layers of complexity: There are a couple of ways to invest internationally: direct investment, depository receipts, or through a fund structure. In any structure, diligence is required to account for different settlement instructions, clearing instructions, regulations of the market, differences in accounting standards, foreign exchange rate fluctuations, counterparty risk, and many other aspects. These layers of complexity also mean higher fees.  
     
  • Currency Risk: When you invest outside the US, you are exposed to currency risk. Currency risk is the risk that unfavorable currency depreciation will negatively impact the value of your investments.

Source: Yahoo! Finance

The chart above illustrates the dollar’s strength relative to the Euro over the past five years. While we don’t expect this trend to persist forever, the takeaway is that there is an added layer of risk and diligence required when investing abroad.

  • Political/Geopolitical Risk: Recent headlines have brought to light the delicate union that makes up the Eurozone. With Brexit underway and the potential for others to follow suit, we feel there are more headlines that will expose the cracks of the Eurozone. While the US is certainly not immune to those risks, why further expose your portfolio to political risk?
  • Risk/Reward Profile: Perhaps our most obvious point is illustrated in the chart below. While past performance is no guarantee of future performance, the annual return for US stocks over the time period 1970 to 2016 surpasses International, Europe, and Pacific stocks and more importantly, with less volatility of returns.

  • Fees: The fees associated when investing in international stocks or mutual funds are often higher. According to the Investment Company Institute, the average expense ratio for an international mutual fund is 1.41% compared to the Vanguard S&P 500 Index Fund which charges 0.04%. Think of the missed appreciation of your investment if you compound that difference in fees over a long-time horizon.

To summarize, while we agree that there may be a valuation advantage to invest abroad in the short run we feel the risks in doing so do not outweigh the incremental short-term outperformance you might achieve. Our preference is to gain exposure by investing in US companies that have global exposure through their revenue sources. We are still optimistic of the US economy and US corporate earnings which according to analysts at S&P Dow Jones Indices is estimated to reach $128.51 per share on the S&P 500 for 2017.

Traditional financial institutions recommend anywhere from 20% to 30% of your equity allocation to international stocks because of the diversification characteristics. It’s important to note though that many of these institutions have underperformed their respective benchmarks because of this large allocation. While we cannot predict the future, history has shown that in times of global crisis the world runs to the US markets for safety. Whether it’s to invest in US Treasuries, US Real Estate, US Securities, or to simply hold the US Dollar, foreign investors know the US is a trusted global leader and there’s a perceived safety net or trust built into our system because of our laws and respect for our citizens. This is in stark contrast to the turmoil that occurs daily in foreign countries and is why we feel the US will remain the reserve currency of the world.

 

Disclosures: Co -authored by Cindy Jones and Patrick R. Wallace. Past Performance is no guarantee of future results.

 

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Covington Investment Advisors, Inc.
301 E. Main Street
Ligonier, PA 15658
Phone: 724-238-0151
Fax: 724-238-0148
Email: messmer.advisors@comcast.net