Corporate Governance is ensuring businesses have the appropriate decision-making processes and controls to ensure that all stakeholders’ interests (shareholders, employees, suppliers, customers, and the community) are balanced. Companies stress this ideology, but it often doesn’t work out for all stakeholders. Some management groups may put the shareholder first, at the expense of quality and innovation, whereas others may let the shareholder drag as management fills their pockets with stock-based compensation. This is one of many examples of unsystematic risk that is carried when investing in an individual company. Other examples include industry risk, competition risk, political risk and so on. Fortunately, unsystematic risk can be reduced through diversification of different companies and systematic or macro risk can be reduced through diversification of different asset classes such as bonds, rare metals, real estate, land, and options etc.
One risk I don’t see investors put under the microscope often is country risk or international risk. This is the risk carried by investing only in your homeland. Even Warren Buffett has forgone global diversification and directed 90% of his wealth to be put in an index that tracks 500 largest US stocks by market capitalization in his will at one point.
Although I do allocate a very small portion of my portfolio to individual assets that I like to research, it is mostly just for fun. I’m a big believer in index investing and the majority of my portfolio is invested in a single ETF (“Exchange-Traded Fund”) with ticker symbol (NYSEARCA:VT). This is the Vanguard Total World Stock ETF. Touting an extremely low expense ratio of 0.07% as of 02/27/2023, The objective of this ETF is to track the performance benchmark that measures the investment return of global stocks. This means VT is passively managed and comprised of many companies throughout the world at market cap weights. In fact, it has 9,572 holding as of 08/31/2023 with the following Region breakdown (YCharts):
Some followers of John Bogle, founder of Vanguard, also known as “Bogleheads”, preach the best portfolio is 100% in VT, or some VT/Bond blend. The quote referenced often is “Don’t look for the needle in the haystack, just buy the haystack!”. By buying the haystack, you dodge risks through poor corporate governance and other unsystematic risks tied to individual companies, industries, and countries. Of course, this limits your reward, but many years of data prove humans aren’t great predictors of the future over the long run. Over the last 10 years, 18% of mutual funds have beat the benchmark S&P 500 and this number dwindles over 20,30, and 40 year stretches when you factor in fees. This means 80% of the time or more, professional institutes using all the data, insider secrets, hedging strategies, and PhDs still manage to lose money compared to the standard index.
Bogleheads or the Efficient Market Theorem says our internal crystal ball is pretty much a bag of hot garbage. They would say we’re better off just matching the market and growing our personal wealth accumulation potential through valuable skills, knowledge, and relationships. Although, Bogleheads don’t all share the same philosophy on capital allocation. Some prefer more international exposure, some prefer more bond exposure, some prefer 100% US based equities. The philosophy of buying the haystack remains the same, but usually there is a sticking point when it comes to international stocks.
The main premise of this article delves into why I prefer an index with exposure to international stocks, rather than an index comprised of 100% US based equities.
The Arguments Against International Exposure
Antagonists against international stocks argue that US companies already implement international strategy by selling goods and services outside their domestic market. Furthermore, there is already a lot of international cooperative alliances between domestic and foreign countries. For example, my Chinese based Lenovo Laptop (OTCPK:LNVGY) comes with a US based Intel Core i7 processor (INTC), and an Nvidia GeForce RTC card (NVDA), which was probably manufactured by Taiwanese Semiconductor Manufacturing Company (TSM). This is a single consumer product with many international hands coming together. Essentially, antagonists of international stocks argue investing in a US index is inherently investing in international markets anyway.
The other argument that antagonists of international stocks bring to the table is that US stocks have outperformed international stocks in recent history both from a risk and reward standpoint.
Since 2011, VT had a standard deviation of 14.72%. This value is the portfolio risk and is calculated through historical price fluctuations of the asset. The best way to understand this value is by comparing it to (VOO), which is a similar Vanguard ETF, but is comprised of the 500 largest US stocks by market cap and have no international exposure. Since 2011, VOO had a standard deviation of 14.34%. This means VT is slightly riskier than VOO using historical data. Not only that, VOO has a much higher expected return of 13.07% versus a still respectable 8.99% for VT. The division of the Expected Return and Standard Deviation is the Sharpe Ratio, or the Reward/Risk measurement. As expected, VOO has a much favorable Sharpe Ratio of 0.851 compared to VT touting only 0.552. So this begs the question: why on earth would anyone favor VT, if VOO offers a better reward for a lower risk?
The Arguments For International Exposure
The key thing to note here is these values were calculated using historical data. But as the saying goes, historical returns do not guarantee future expectations. US stocks have not always been a powerhouse throughout history.
Yes, the US has outperformed international stocks over the last decade and the majority of the last three decades, but this does not guarantee they will continue to do so. US stocks are still cyclical and there is no way to predict which way it will go in the future. Reverting to the example of my laptop, the US showed it’s Achillies heel during the pandemic with the chip shortage. With most semiconductors being manufactured by TSMC, and little to no semiconductor manufacturing capabilities by the US, a bit of a global scramble was caused to say the least. The US responded by passing the Chip Act to help US manufactures like Intel speed up their facility production. Meanwhile, investors were dipping in and out of US and international chip companies. Even our dear friends Warren Buffett and Charlie Munger entered a position in TSMC, only to sell a quarter later with Charlie saying, “What do we know about semiconductors?”. The truth is, most investors don’t truly understand this industry, or which country will win, or who has a true competitive advantage. The product and industry are too complex for the average investor. Picking a single company or even a single country to win this race is most likely a loser’s game over the run.
However, investors can still have exposure to Taiwan and US based chip companies. For refence, 1.8% of the holdings in VT are Taiwanese stocks including TSMC, and 61.10% of US stocks contain Intel, NVDA, AMD and other US semiconductor companies. You have exposure to the to the industry and different companies but limit your downside in case things go sour.
Another argument for international exposure is comparing the market cap weight of US exposure in VT compared to the US GDP as a percentage of the total word’s GDP.
The US GDP as % of World GDP has been on a downward spiral since the 70s, floating around 25.21% now. Comparing this to the massive 61.10% market cap weight of US stocks in VT, one could argue US stocks are grossly overvalued. Should 25% of the world GDP be valued at 60% of the world’s market? Maybe, but also, maybe not.
Though US stocks have been on a rampage for many decades, I don’t see evidence that they will undoubtedly continue to do so. I think it makes sense to have exposure to not only many companies and industries, but many different countries as well. As globalization continues to grow and countries such as Taiwan continue to surprise the world, I’d be hard pressed to confidently say an index based on only US stocks is the best play for a 10,20-, or 30-year horizon. To me, the true haystack is VT.