Three of the most popular international ETFs are Vanguard’s VWO, VEA, and VXUS. Is there one that reigns supreme to hold alongside U.S. stocks?
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Diversifying with International Stocks
Index investors in the U.S. usually know it’s a good idea to diversify in equities outside the United States. At global market weights, U.S. stocks only comprise about half of the global market. International stocks don’t move in perfect lockstep with U.S. stocks, offering a diversification benefit. If U.S. stocks are declining, international stocks may be doing well, and vice versa.
The U.S. is a single country. No single country consistently outperforms all the others in the world. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal. Meb Faber found that if you look at the past 70 years, the U.S. stock market has outperformed foreign stocks by 1% per year, but all of that outperformance has come after 2009.
During the period 1970 to 2008, for example, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio. Specifically, international stocks outperformed the U.S. in the years 1986-1988, 1993, 1999, 2002-2007, 2012, and 2017.
In short, geographic diversification in equities has huge potential upside and little downside for investors.
VEA, VWO, and VXUS from Vanguard
What is perhaps less clear is how exactly one should go about implementing that diversification in ex-US stocks. The most popular choice by far is VXUS, Vanguard’s total international stock market fund. This fund is a crucial component of both the Bogleheads 3-Fund and 4-Fund portfolios.
Investors may not realize what the underlying components of a broad index fund like VXUS are, though, and how those components behave relative to U.S. stocks. VXUS is roughly 75% Developed Markets and 25% Emerging Markets. But as we would expect, Developed Markets are highly correlated with the U.S. market, and thus don’t offer much of a diversification benefit. Emerging Markets offer a consistently lower correlation to the U.S. market and are thus the superior diversifier. Specifically, over the last 20 years, ex-US Developed Markets and the U.S. have had an average monthly correlation of about 0.89, versus 0.79 for Emerging Markets. As an added bonus, Emerging Markets have paid a significant risk premium historically and have higher future expected returns compared to Developed Markets.
VEA is Vanguard’s broad index fund for Developed Markets. VWO is the one for Emerging Markets. Thus VXUS is roughly 75/25 VEA/VWO. So for a realistic example where the portfolio has home country bias (most people do), a 100% equities portfolio of 80% VTI (total U.S. stock market) and 20% VXUS unfortunately only has about 5% exposure to Emerging Markets.
To remedy this, we have to forego the use of VXUS and use its components VEA and VWO to get more granular. I personally choose to equally weight Developed Markets and Emerging Markets in international stocks in my own portfolio to take advantage of this superior diversification and greater expected returns while still including the many countries in Developed Markets that may outperform the U.S. during certain periods.
Let’s look at some historical performance of this idea by switching the example to a 100% stocks portfolio of 50% U.S. stocks and 50% international stocks to keep things simple. Let’s assume the use of VTI (total U.S. stock market) for the U.S. side. Here are a few options I’ll propose for the international side:
- 100% VXUS (again, we know this is about a 3:1 ratio of Developed Markets to Emerging Markets)
- 50% VEA, 50% VWO (half Developed Markets, half Emerging Markets)
- 100% VWO (all Emerging Markets; no Developed Markets)
Here’s how these three options worked out historically from 1995 through February, 2021:
As we’d expect based on the aforementioned geographical correlations and risk premium of Emerging Markets, we can see that overweighting Emerging Markets relative to their global market weight has resulted in greater general returns and risk-adjusted returns historically.
Does this mean investors should use Emerging Markets for their entire ex-US stocks position? Probably not. Again, we wouldn’t want to miss out on all the developed countries around the world. That said, it shows we can probably reliably expect a greater diversification benefit and higher returns over the long term by giving a little more weight to Emerging Markets. I keep it pretty simple and just give equal weight to Developed Markets and Emerging Markets, i.e. a 1:1 ratio instead of VXUS’s 3:1.
How do you weight Developed Markets and Emerging Markets in your portfolio? Let me know in the comments.
Disclosure: I am long VEA and VWO in my own portfolio.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.