4 International ETFs to Consider for Diversifying Your Portfolio

There are two primary reasons to consider adding international (non-US) stocks to your portfolio.

The first reason is the benefit of diversification. Historically, there have been periods when international stocks have outperformed US stocks over extended durations. This trend underscores the importance of geographic diversity in an investment portfolio, given the increasingly global nature of the market. Financial advisors, such as those from Schwab, suggest that international investments should constitute 5% to 25% of an investor’s total stock market holdings. This approach not only opens up opportunities for growth but also helps in mitigating risks associated with market fluctuations.

According to Schwab, allocating between 5% and 25% of your investment portfolio to international stocks is advisable for both diversification benefits and the potential for long-term growth.

International stocks often exhibit low correlation with US stocks, which can enhance volatility-adjusted returns over time. This diversification benefit is crucial because different markets around the world may perform differently at any given time. By investing in a diversified international ETF, investors can capitalize on these variations to potentially improve their portfolio’s performance.

Another compelling reason to consider international ETFs is their valuation and yield. International ETFs can offer yields that are significantly higher than those of the S&P 500, making them attractive for investors seeking income in addition to growth. For example, some highly regarded international ETFs recommended by Morningstar include the Vanguard Total International Stock ETF (VXUS) with a 3-star gold rating and a low expense ratio of 0.07%, and the Vanguard International High-Yield (VYMI) with a 4-star silver rating and an expense ratio of 0.22%. These ETFs provide cost-effective access to high-yield international companies, potentially enhancing an investor’s income and growth prospects.

Moreover, the yields on international stocks can be substantially higher than those found in the US market, with forecasts for global earnings growth being similar or even slightly higher than those expected in the US. This suggests that international high-yield investments could offer superior long-term total returns, better risk-adjusted returns, and quicker doubling times compared to US stocks. For instance, while the S&P 500 is expected to double investments every 14 years, international high-yield investments might achieve this in approximately 11 years, highlighting their potential for enhanced returns.

Today we will cover these 4 international ETFs:

Detailed Analysis of Each International ETFs:

Vanguard Total International Stock ETF (VXUS): As one of the largest international ETFs, VXUS boasts $51 billion in assets under management, offering outstanding diversification with an ultralow fee structure. This ETF provides exposure to over 7,000 stocks from foreign developed and emerging markets, following the FTSE Global All Cap ex U.S. Index. Its broad portfolio and low expense ratio have earned it a Gold rating from Morningstar. With only 9% of its assets in its ten largest positions, VXUS exemplifies diversification, including a significant portion of emerging-market stocks. However, its exposure to expensive stocks can increase with market hype, which is a minor concern against its long-term appeal. The ETF’s average PE ratio stands at a low 11X, with a cash flow multiple of 6X. While its financial health and moats may not match those of US ETFs, the attractive free cash flow (FCF) yield and a conservative payout ratio of 36% are notable strengths.

Vanguard International High Dividend Yield Index (VYMI): VYMI strikes a balance between high dividend yield and risk, focusing on larger, more stable firms. Recently downgraded to a Silver rating by Morningstar, it still offers a compelling investment case by tracking the FTSE All-World ex U.S. High Dividend Yield Index. This ETF opts for stocks representing the higher-yielding half of the dividend-paying universe, excluding REITs, to maintain a value orientation while managing risk. It boasts an average PE ratio of 9.4X and a cash flow multiple of 4.7X, coupled with an attractive 5% yield. Despite some financial health concerns and a moat rating of C+, its broad diversification across sectors and a 44% very safe payout ratio remain appealing. VYMI is highly diversified globally, including significant allocations to Europe, Asia, and a mix of developed and emerging markets.

Invesco International Dividend Achievers ETF: This ETF focuses on companies that have consistently increased their dividends for at least five consecutive years. It is based on the NASDAQ International Dividend Achievers Index and invests in a mix of American Depository Receipts, Global Depositary Receipts, and non-U.S. common stocks. Despite the perceived modesty of a five-year growth streak, it offers an attractive PE ratio of 12.5X and a cash flow multiple of 7.6X. The ETF is notable for its 58% wide and narrow moat ratings and a safe payout ratio of 53%. However, it is less diversified than VXUS and VYMI, with a heavy focus on North America (Canada) and Europe. It includes just 49 companies, indicating a higher turnover but a concentrated selection of high-yield blue-chips.

Invesco S&P International Developed High Dividend Low Volatility ETF (IDHD): With $22.3 million in assets, IDHD is on the smaller side and focuses on high dividend yields with lower volatility, based on the S&P EPAC Ex-Korea Low Volatility High Dividend Index. This ETF offers an intriguing blend of safety and income, with a PE ratio of 13.8X and a cash flow multiple of 6.7X, alongside one of the industry’s highest yields at 5.5%. While it covers every sector except consumer discretionary and energy, it provides significant exposure to Europe, Asia, and an effective pathway to Japanese and Singaporean markets. The fund’s future might be uncertain due to its size, but its current composition and strategy offer a unique investment opportunity with a high annual turnover rate of 73%.

Reviewing Historical Performance and Future Projections

Vanguard Total International Stock ETF (VXUS):

• Historical Performance: Since its inception in May 1996 (noting VGTSX as its mutual fund counterpart with the same start date), international stocks have shown disappointing returns over 26 years. Despite a period in the 2000s when international markets outperformed the US, the overall picture reveals a stark underperformance: a 2% compound annual growth rate (CAGR) after inflation for VXUS compared to a 6% for the S&P 500. This underperformance extends across significant market downturns, with international stocks offering lower returns, higher volatility, and longer bear market recovery times.
• Dividend Growth: Historical data indicates slower dividend growth for VXUS, with a shift from $15 to $101 income per $1,000 investment from 1997 to 2022. Future projections are more optimistic, with analysts forecasting around 6.5% real income growth, adjusted for risk, inflation, and taxes, notably higher than the S&P 500’s historical growth rates.

Vanguard International High Dividend Yield Index ETF (VYMI):

• Historical Performance: Over its seven-year history since April 2016, VYMI has also lagged, with a real return CAGR of just 1.3% compared to the S&P 500’s 8.9%. Despite this, VYMI has shown relatively consistent annual income growth, excluding pandemic impacts.
• Dividend Growth: VYMI’s dividend growth impresses with an 12% annual increase from 2017 to 2021. Future income growth forecasts are ambitious, with expectations of 9% risk and tax-adjusted growth, suggesting a potential for substantial income acceleration despite past underperformance.

Invesco International Dividend Achievers ETF (PID):

• Historical Performance: Since October 2005, PID has slightly outperformed VXUS but still trails significantly behind the S&P 500, with a 1.9% real return CAGR over 18 years. The ETF’s focus on dividend growth has not translated into consistent income growth, mirroring the variability seen in VXUS’s performance.
• Dividend Growth: PID has mirrored VXUS in delivering annual income growth over the past 15 years, underwhelming when compared to the S&P 500’s. Future projections, however, suggest a potential for doubling this growth rate, with a more conservative expectation of around 6% income growth from PID, roughly twice that of the S&P 500’s projections.

Invesco S&P International Developed High Dividend Low Volatility ETF (IDHD):

• Historical Performance: In its six-year existence since January 2017, IDHD’s standout feature has been its lower volatility, although it has not shielded investors from downturns as effectively as hoped. With a -3% real return CAGR, its performance has been disappointing, even when considering its lessened volatility.
• Dividend Growth: IDHD’s income growth has lagged behind VYMI’s, but future income growth forecasts are notably optimistic, with a predicted 9% real income growth. This forecast, while ambitious, indicates a potential for income growth significantly above the S&P 500, despite existing skepticism regarding these projections.

In summary, while historical data may not always inspire confidence, the forward-looking income growth projections for these ETFs suggest a brighter future. However, investors should approach these forecasts with caution, balancing optimism with a critical analysis of past performance trends and market conditions.

The Challenges of Investing in International ETFs

Investing in international ETFs, while offering diversification and exposure to global markets, comes with its own set of challenges, underscoring the importance of understanding these complexities before making investment decisions.

Historical Context and Performance:

• Long-term Perspective: Historically, US companies have consistently outperformed their international counterparts. This trend spans various periods, including since 1950, 1996, and more recently, the last five and ten years. The dominance of US technology companies has played a significant role in the past decade, but when considering 72 years of data, the sustained outperformance gains statistical significance. According to Fidelity, a 97% likelihood suggests that there’s something inherently advantageous about US companies, attributed to their ability to adapt and thrive through numerous economic cycles and challenges.

Risks and Taxation Complexities:

• Risk Profiles: International investments introduce a variety of risk factors not as prevalent in domestic markets. These include, but are not limited to, political instability, currency fluctuations, and differences in regulatory environments.
• Currency Considerations: While currency values tend to mean revert over time, suggesting long-term hedging may not be beneficial, short-term currency volatility can significantly impact returns.
• Tax Implications: Dividends from foreign equities are subject to foreign tax withholdings, which vary widely depending on the investor’s country of residence, the issuing company’s home country, and existing tax treaties. These complexities can affect the net income investors receive from their international investments. The IRS treats dividends and interest from ETFs similarly to those from direct stock or bond holdings, with gains taxed according to the nature of the underlying assets.

Navigating International Dividend Taxes:

• The intricate landscape of global dividend taxation necessitates a thorough understanding of the applicable rates and treaties, which can influence the overall tax burden on foreign income.

Strategic Considerations for Your Portfolio:

• Evaluating ETF Options: Among the reviewed international high-yield ETFs, VYMI stands out with potential for future performance improvements, although it may not achieve the optimistic 12% long-term returns forecasted by some analysts. VXUS, despite its strong theoretical foundation and Vanguard’s effective execution, faces the significant hurdle of historical data suggesting inherent advantages of US companies. PID and IDHD, while appealing in concept, have shown limitations in their ability to outperform, particularly in terms of dividend growth and volatility management.
• Building a Custom Strategy: Given the mixed historical performance and the unique challenges of international investing, investors might consider a more tailored approach to global exposure. This could involve a selective combination of ETFs, or even constructing a personalized portfolio that aligns with individual risk tolerance, investment goals, and tax considerations.

Conclusion: While international ETFs can play a crucial role in diversifying and potentially enhancing your retirement portfolio, the decision to invest should be informed by a deep understanding of the associated risks, historical performance, and tax implications. For some, carefully selected ETFs like VYMI may offer a strategic opportunity, but for others, a custom-built approach to international investing might be more appropriate, ensuring a well-rounded and resilient investment strategy.