What Are International Equity Funds?

If you want diversification, going international is key

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Even if you don't know much about mutual funds, you have probably had access to an international equity fund in your 401(k) or IRA. So what is an international equity mutual fund, and who needs one?

First, let's tackle the equity part. An equity is a stock -- a share or shares of a company that you can buy or sell. Most mutual funds that aren't all-bond funds hold at least a portion of equities. Equities are more risky to own than bonds but historically offer higher returns. (A lot of wealth, including that of Warren Buffett, is built through owning stocks.)

International equities are stocks of non-U.S. companies. According to a report by Vanguard, non-U.S. companies represent more than half of the global market capitalization. In other words, non-U.S. companies represent more than half of what all of the companies in the world are worth. If you don't invest internationally, you are missing out on investing in a lot of important companies.

International Equities Can Boost Your Returns

Owning international equities can also help boost your returns. Between 1970 and 2016, the average annual rate of return from owning international stocks in developed markets was 8.6%. During this same period, the return of large-cap U.S. stocks was 10.3%.

And because U.S. markets and international markets don't always move in the same way (international beat U.S. stocks in the 1970s and 1980s, the U.S. dominated in the 1990s, international performed slightly better in the 2000s), owning international stocks can help reduce a portfolio's overall risk. When one part of the world's markets is underperforming, another may be performing well. Owning both helps to bring balance to a portfolio.

Not Global Equity Funds

International equity funds are not to be confused with global equity funds. What's the difference? Global equity funds are made up of stocks of companies anywhere, meaning both U.S. and non-U.S. companies.

If you invest in a global fund to get international exposure, you may find that the majority of the fund's holdings is in U.S. companies. You may even already own those companies in another equity fund. If you want diversification, international is the word to look for.

Types of International Equities

There are two types of international funds: Those that invest in developed countries, and those that invest in emerging markets. Emerging markets are countries or regions that have less developed economies but a lot of potential for growth. But because most of these countries, or their markets, are not highly regulated, there can be risks involved with investing there. With greater risk, however, often comes a greater potential return. Emerging market returns in the 25 years between 1987 and 2012 yielded an average of 12.5% per year.

Typically the international equity funds that are included in a 401(k) plan are large-cap equity funds that invest in developed countries, such as Japan, Germany, and the United Kingdom. If a plan does offer emerging markets equities, it will probably be in a separate fund. Financial advisors often recommend that investors who choose to own emerging market equities should limit exposure to no more than 5 to 10% of an overall portfolio.

Risks of Investing in International Equities

There are several types of risks associated with investing internationally:

  • Currency risk: The value of the dollar will differ from the value of the fund's underlying currencies. This can help to boost your returns when the dollar is weaker, regardless of how the investments are performing. But when the dollar is strong, it can have the opposite effect.
  • Political risk: The stability and oversight of local governments matter to the markets. Anytime you are investing in a foreign country (or even your own) there is a risk that the economy or government may face unforeseen troubles.
  • Liquidity risk: The U.S. stock market is fairly liquid, meaning that a large volume of stocks is bought and sold on it every day. So when the average investor wants to sell a stock, there's usually a willing buyer. What if there were no buyer and you had no choice but to hold onto it until one came along? That's an illiquid market. Foreign markets have a lower trading volume than U.S. markets.

There are other risks to consider with international funds. Are the accounting and reporting standards as high as we have in the U.S.? Are the fees for investing in these stocks greater than those charged to invest in U.S. stocks? A fund that is managed well will anticipate and understand these risks to some extent.

The Bottom Line for Investors

  • If you want a truly diversified portfolio, having an investment in international equities is essential.
  • While there are some risks, and some investors fear the unknown, international equities make up a large part of the world market's potential investment growth.
  • Experts tend to recommend that no more than 20% to 35% of a portfolio be allocated to international equities, or even less depending on your risk tolerance and focus on growth.
  • Conservative investors will favor developed markets over emerging markets.
  • Look for the word "international" as opposed to "global" when choosing a foreign investment fund.

Disclaimer: The content on this site is provided for information and discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.