VXUS: Why Buying The International Haystack Does Not Generate Alpha

seekingalpha03-28

William_Potter In October 2023, I wrote an article on Vanguard Total World Stock Index Fund ETF Shares (VT) making a clear case its significant underperformance and tax liabilities had no place in my ...

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Though I did point interested investors to Vanguard Total International Stock Index Fund ETF Shares (NASDAQ:VXUS) as a means to mitigate their tax liability and customize the allocation to potentially generate higher yields, more diversification, and less volatility in returns long-term. While there's generally a good case to add some level of international stocks to your portfolio, particularly for retirement, I don't believe VXUS is the best choice and feel more research should be done in the space to determine a more strategic international partner for a US focused portfolio. Fund Strategy and Performance VXUS focuses on investing in global equity markets outside the US, targeting companies from various sectors and market capitalizations. The fund aims to replicate the performance of the FTSE Global All Cap Ex-US Index. It is a well diversified market capitalization weighted ETF with a staggering 8598 holdings, essentially owning all publicly traded companies domiciled outside of the USA. The top decile of holdings constitute just under 10% of the funds weight. Notable names include Toyota Motor Corp (TM), Nestle SA (OTCPK:NSRGY), Samsung Electronics Co Ltd (OTCPK:SSNLF), and SAP SE (SAP). The fund has a TTM dividend yield of 3.31%, a fair bit higher than your typical US total market or large cap ETF in the 1.3% range. VXUS Holdings Breakdown (Seeking Alpha) Backtesting Analysis US vs. VXUS Historical Backtest 2011-2024 Data by YCharts Data by YCharts Since the inception of VXUS, Vanguard Total Stock Market Index Fund ETF Shares (VTI) have outperformed VXUS by almost 5x in the last 13 years at 394% vs. 80%. Of note, the S&P 500, using Vanguard S&P 500 ETF (VOO) as a surrogate, outperformed VXUS by more than 5x at almost 420% total return. Strong economic growth with the US' flexible business environment, monetary status and policy like a strong dollar and low-interest rates, and technological innovation i.e. most of the leading tech company stocks are in the S&P 500, are attributed to this period of outperformance. Ex-US Historical Backtesting 1986-2024 Ex-US vs. US Stocks 1986-2024 Log Graph (Portfolio Visualizer) Ex-US vs. US Stocks 1986-2024 Performance Summary (Portfolio Visualizer) Let's look further back at Ex-US vs. US performance from 1986-2024 using portfolio visualizer. It wasn't until 1995 that US stocks overtook Ex-US stocks and haven't looked back since. Note, the graph below is on a logarithmic scale. During this period, US stocks outperformed Ex-US stocks by a 4% annualized return at 10.69% vs. 6.71% respectively. This amounts to more than 4x more money earned in this example: $10k investing initially grew to $119k for Ex-US and $482k US. A 4% difference compounded over almost 40 years really adds up. Ex-US vs. US Stocks 1986-2024 Annual Returns (Portfolio Visualizer) What's interesting is even after 1995, there are a fair amount of years when Ex-US outperforms US stocks indicated by the blue bars in the bar chart above. These years really float the short-term argument to have an allocation of your portfolio in Ex-US stocks. However, Ex-US tends to have more drawdown in bad years than US stocks and US stocks tend to outperform relatively higher than Ex-US stocks in good years. Ex-US Historical Backtesting 1971-2024 Many Bogleheads will immediately argue that 1986 is not far enough of a backtest to make a case for Ex-US stock allocation. This site gives a great case for international investing and I sourced key stats and figures from there below. Note, the focus in on comparing Ex-US vs. the S&P 500 returns in this section.   Ex-US vs. US Annual Returns 1970-2023 (MSCI Data) It's noted that over different time periods, Ex-US and US stocks exchange outperformance. The annual return differences can be quite drastic, thus making a great case for diversifying into international stocks. Even recently in 2022-2023 Ex-US at least performed less worse than US stocks. One objection I have to this neat oscillating table is the years are obviously selected to show favor to each allocation. International stocks had higher returns than US stocks 25 of 53 times vs. 28 times for US stocks. Of course, we never know when these periods of outperformance will be, but from 1970-2023, US and Ex-US stocks had an annualized return of 10.5% and 9.1% respectively. A 1.4% difference still adds up to a decent difference in portfolio balance over the course of 50+ years, but the added diversification stabilizes returns over the decades in return for less annualized return. Even more compelling is that the outperformance has taken place during the latest cycle. From 1970-2012, the annual returns were almost the same with US and Ex-US stocks returning 9.7% and 9.6% annualized returns respectively. Risk Analysis Driving International Exposure Ex-US vs. US Valuation Differences 1980-2023 (Bloomberg, MSCI, Consensus Economics) A key reason cited for this outperformance by US stocks are valuation changes. International stocks went from relatively expensive to relatively cheap and vice-versa for US stocks. Though, I find the ratio they plot to be too sensitive. Even from 2006-2012 the valuation ratio increases above 1 near where it is now yet US and Ex-US stocks performed the same until 2012 as previously mentioned. They are also using the EAFE Index here which contains 795 stocks from 21 countries. It's a great benchmark but it doesn't fully represent Ex-US stocks. Also, valuations being high doesn't mean they must automatically come down: international stocks may just need to catch up to US valuations. Volatility Curve Function with International Exposure (TIAA) In line with the valuation differences favoring international stocks currently, maintaining international exposure long-term may also be wise despite short-term market fluctuations to decrease portfolio volatility. Based on market capitalization globally, allocating about 60% to US stocks and the remaining 40% to non-US stocks would be the current weighting. The plot below illustrates that gradually adding non-US stocks to a US portfolio reduces volatility, with optimal diversification achieved when non-US equity represents about 35% to 40% of total equity exposure. Though interestingly, the rate of change of the curve is less with more non-US stocks being added. Notably at the extremes, 0% and 70% non-US stocks have the same volatility at 17% while 100% non-US stocks has the highest volatility at 18.5%. I personally can't wrap my head around more than 20% non-US stocks in my portfolio unless I had compelling research from more strategic funds. Moving Forward While recency bias may lead inexperienced investors to believe international stocks have no place in one's portfolio, long-term data to the 1970s shows a compelling case. In my view, both cases for and against international stock allocation are far too sensitive to specific periods of time. We see that by adding in the 1970s, a compelling case can be made for International stocks. By adding in the last 10 years, an even more compelling case can be made for US stock portfolio focus.  Overall, I don't believe a fund like VXUS is the best way to invest in international stocks. VXUS is just buying the haystack of 8500+ companies and my intuition is there are more strategic international investment options to amplify the benefits international stocks give to US focused investors: higher yield, diversification, and smoothing of returns long-term. One relatively newer fund that has caught my attention as an Schwab U.S. Dividend Equity ETF (SCHD) investor is it's foreign cousin Schwab International Dividend Equity ETF (SCHY). I will be writing a separate article focusing on this ETF next.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422092736"}