A longtime financial planner who started in the early 1980s, Stephen Barnes has been a believer in the benefits of investing outside the U.S. from the beginning. The economics side of his original degree in economics and business, he said, “introduced me to the non-U.S. side of the world,” while his later CFA program “really opened my eyes to opportunities for returns and diversification.”
When he transitioned his firm to fee-only in the late 1980s, non-U.S. diversification was “one of the core things we put into our original investment philosophy.” And the interest went even deeper: Barnes was also a former staff writer for the Motley Fool, and used that fascination with investing beyond U.S. shores to cover foreign markets from 1994–1998.
Plus, there was the practical side of what he saw as an advisor in Arizona. “We’re close to and hear a lot about Mexico,” he said, “and the late ’80s was a really amazing time to be invested in Mexico—and then became awful with the Tequila crisis [in 1994] and that made me want to learn more.”
Back then, he said, Mexico’s Bolsa—the Mexican Stock Exchange, Bolsa Mexicana de Valores (BMV) “had quite a run, with amazing returns not unlike the dotcom bubble in the U.S. But the intriguing thing was, for a non-peso investor, you gave away most of those returns with the depreciation of the peso. It was a quick education on how currency exchange rates can impact returns negatively or positively.”
While Barnes uses international investing in portfolio diversification, he said that it’s definitely not the main factor to consider. The main factor is risk.
“On a valuation basis, with very few exceptions, anywhere in the world is cheaper than the U.S., and I think that has important implications for long-term investment returns. The problem with valuation-based returns is that it’s not a good timing tool. If you think you can make a quick killing—by selling or buying a cheap region—you can get into trouble,” he said.
“Stupid cheap areas are Greece, Russia, those kind of places. You can buy world-class businesses there at ridiculously cheap levels.” In the U.S., he said, there just aren’t that many cheap companies available for investment. But, that said, “[t]he other thing to bear in mind any time we talk about foreign vs. domestic investing is that it’s a distant number two in terms of things to look at in diversifying a portfolio. The biggest decision is risky vs. nonrisky; the stock/bond mix drives the risk and return of the portfolio. Whether or not you diversify them geographically is a distant number two.”
Another point he makes is that there’s not a lot of diversification in non-U.S. developed countries. However, there’s “clearly a differentiation in terms of the pattern of returns between emerging markets and the rest of the world.”
Barnes said that while he has used ADRs in the past, the last 20 years have seen a large expansion in non-U.S. investments. Now he relies on “more funds and ETFs for non-U.S. exposures.” For emerging markets, he uses Vanguard’s open-end emerging markets fund, along with a couple of other ETFs. In addition, bonds are diversified outside the U.S.
All this diversification at present totals “at or probably above 40% of the equity portion of the portfolio. That’s higher than our setpoint normal percentage,” but it’s “nfluenced by the attractiveness of valuation overseas.”
How do clients react to such a large concentration of non-U.S. investments? Barnes said that his firm spends a lot of time educating clients. The behavioral research on home country bias around the world indicates that it’s not just a U.S. phenomenon.
“The best way to explain it is to look at the FTSE world country index. It’s 48% U.S. companies and 52% non-U.S. If you wanted a geographically agnostic portfolio, it would be 48% U.S.” However, Barnes said that, “for a U.S. investor, I’d argue that your future spending will likely be done in U.S. dollars, and modify that a bit [so as not to have] such an extreme nondollar exposure.” Still, he adds, dollar diversification is meaningful.
But that doesn’t mean it’s always an easy sell. “It’s difficult to have extreme positions like that, particularly in the U.S., where the news is almost always about what U.S. markets have done. It’s difficult to have exposure overseas, and read and listen all day long to what the U.S. market has done. You don’t want to go into a non-U.S.-diversified portfolio without understanding that you will from time to time underperform the U.S. markets.”
Diversification, said Barnes, “means by itself that you always have something that’s underperforming. That’s literally what it means and that’s the objective. Everything is supposed to provide you with a decent return long term, but not all at the same time.”
Of his time at the Motley Fool, Barnes said that the early community there was “not exactly receptive” to the idea of international diversification. “It didn’t strike either Tom or Dave [Gardner, the founders of the Motley Fool] or a broad cross-section of the entourage as a particularly Foolish place to invest,” Barnes said. “But to their credit, they warmed to the topic and realized it could be. They were quite gracious in allowing me to become part of the community.”