What Is International Equities?
International equities refer to ownership shares in companies that are domiciled and primarily operate outside an investor's home country. For a U.S. investor, this means stocks of companies based in countries other than the United States. Investing in international equities is a fundamental component of effective asset allocation and portfolio theory, aiming to enhance a portfolio's overall diversification.
These investments allow investors to gain exposure to global economic growth, access industries not strongly represented domestically, and potentially reduce portfolio volatility by spreading risk across multiple economies and markets. Investors can access international equities through various vehicles, including mutual funds, exchange-traded funds (ETFs), or directly through American Depositary Receipts (ADRs) that trade on domestic exchanges.
History and Origin
The ability to invest in international equities has evolved significantly alongside the liberalization and integration of global capital markets. While cross-border investments have existed for centuries, their scale and accessibility to individual investors expanded dramatically in the late 20th century. The period from the late 19th to the early 20th century saw an impressive degree of global financial integration, only to be disrupted by two World Wars and the Great Depression. Post-World War II, a more regulated environment emerged, with many countries imposing capital controls.7
However, starting in the 1970s and accelerating in the 1980s and 1990s, a widespread movement towards financial deregulation and the dismantling of capital controls facilitated greater cross-border capital flows. Technological advancements, particularly in telecommunications and electronic trading platforms, further reduced the costs and increased the speed of international transactions, making it easier for investors to participate in foreign stock markets.6 This era ushered in what is often termed "globalization," fundamentally reshaping how individuals and institutions could invest beyond their national borders.5
Key Takeaways
- International equities offer exposure to companies operating outside an investor's home country.
- They are a key tool for portfolio diversification, potentially reducing overall risk and enhancing returns.
- Access methods include mutual funds, ETFs, and American Depositary Receipts (ADRs).
- Investors must consider additional risks such as currency fluctuations and geopolitical events.
- The global financial landscape has increasingly integrated, making international investing more accessible.
Interpreting International Equities
Interpreting the role and performance of international equities within a portfolio requires considering various factors beyond just financial returns. The primary motivation for including international equities is often diversification, as foreign markets may not move in perfect lockstep with domestic ones. This lack of perfect correlation can help smooth out overall portfolio returns. For example, during periods of domestic economic slowdown, strong performance in emerging markets or other developed markets could offset losses.
However, interpreting international equity performance also involves understanding additional complexities such as currency risk, political stability, and different accounting standards. A strong foreign market might see its gains eroded for a domestic investor if the foreign currency depreciates against their home currency. Conversely, a weakening foreign market might still yield positive returns if the foreign currency significantly strengthens. Therefore, investors often look at both local currency returns and U.S. dollar-denomined returns when evaluating international equity performance.
Hypothetical Example
Consider an investor, Sarah, who has a portfolio consisting solely of U.S. stocks. She decides to incorporate international equities to enhance her portfolio construction and diversify her holdings.
Sarah invests $10,000 into a globally diversified exchange-traded fund (ETF) that tracks a broad international equity index. This ETF holds stocks from various countries, including Japan, Germany, the UK, and several emerging markets.
In a given year, suppose the U.S. stock market experiences a modest gain of 5%, but the international markets covered by Sarah's ETF return 12%. Her initial $10,000 international equity investment would grow to $11,200. This example illustrates how international equities can provide growth opportunities even when domestic markets are underperforming or offering more modest returns, contributing to her overall portfolio's performance.
Practical Applications
International equities are widely applied in modern investment strategies, serving as a core component of many long-term investment horizon portfolios. Investors commonly use them to achieve geographical diversification, spreading capital across different regions and countries to mitigate country-specific economic downturns or political events. This approach aligns with sound risk management principles.
A common application is within global asset allocation models, where portfolios are structured to include a specific percentage of international stocks alongside domestic stocks and other asset classes. For instance, some investors aim for a global market capitalization weight, reflecting the proportion of each country's stock market value relative to the total global market.4 Individual investors typically access international equities through globally diversified mutual funds and exchange-traded funds (ETFs) offered by U.S.-registered firms, which simplifies the process and provides regulatory oversight.3 These funds hold a basket of foreign stocks, offering immediate diversification across many international companies.
Limitations and Criticisms
While international equities offer compelling benefits, they also come with specific limitations and criticisms that investors should consider. One significant concern is increased currency risk, as fluctuations in exchange rates can erode or amplify investment returns when converting foreign earnings back to the investor's home currency. For instance, if the U.S. dollar strengthens against a foreign currency, the returns from investments in that country, when converted to dollars, will be lower.
Another limitation is potentially higher volatility and geopolitical risk. Some international markets, especially emerging markets, can be more susceptible to political instability, economic crises, or less transparent regulatory environments, which can lead to sharper price swings. Additionally, some argue that large multinational domestic companies already provide sufficient international exposure, as much of their revenue often comes from overseas operations. However, proponents of dedicated international equity allocation counter that this argument misses the point of capturing the distinct behavior and economic cycles of foreign stock markets, which cannot be achieved solely through domestic multinational exposure.2 The International Monetary Fund (IMF) regularly assesses global financial stability risks, including those that could impact international equity markets, highlighting issues like elevated asset valuations and increasing debt levels.1
International Equities vs. Domestic Equities
The distinction between international equities and domestic equities hinges on the country of incorporation and primary operations of the underlying companies relative to the investor's home country. Domestic equities represent ownership in companies based within an investor's own nation, such as U.S. companies for a U.S.-based investor. International equities, conversely, are shares in companies located outside that home nation.
The confusion often arises because many large domestic companies have significant international operations and generate a substantial portion of their revenue from abroad. This leads some to believe that investing solely in domestic large-cap stocks already provides sufficient global exposure. However, the performance drivers of a stock are tied not just to where it earns revenue but also to the economic, regulatory, and market conditions of its primary listing and domicile. Therefore, true geographical diversification and exposure to unique market cycles and industry landscapes worldwide are achieved by investing directly in international equities, which reflect the performance of foreign stock markets and economies.
FAQs
Why should I invest in international equities?
Investing in international equities can provide greater diversification for your portfolio, potentially reducing overall risk by spreading your investments across different economies and markets. It also offers exposure to growth opportunities in foreign countries and industries that may not be available domestically.
How can I buy international equities?
Individual investors typically gain exposure to international equities through U.S.-registered mutual funds or exchange-traded funds (ETFs) that focus on international markets. You can also invest in American Depositary Receipts (ADRs) that trade on U.S. exchanges, or, for more sophisticated investors, directly on foreign stock exchanges.
Are international equities riskier than domestic equities?
International equities often carry additional risks compared to domestic ones, such as currency risk, geopolitical risk, and differences in regulatory environments or accounting standards. However, these risks can be mitigated through broad diversification within the international equity component of your asset allocation.
What is a good allocation for international equities in a portfolio?
There's no single "best" allocation, as it depends on an individual's financial goals, risk tolerance, and investment horizon. However, many financial professionals recommend an international equity allocation ranging from 20% to 50% of the total equity portion of a portfolio to achieve meaningful diversification benefits. Some even suggest a global market capitalization weight.