Quality abroad: A time-tested approach for international investing

• Individual investors may question investing in international stocks when “what they know” has outperformed for over a decade.
• Adding in international quality exposure, may make investing abroad more palatable for end clients, while also adding in a well-known driver of return.
• International quality has actually been more persistent and more diversifying than U.S. quality.

A well-known behavioral bias displayed by many investors is called home country bias. This phenomenon leads to investors overweighting domestic stocks within their equity allocations relative to their market cap weight globally. For example, a U.S.-based investor may hold only U.S. stocks in his portfolio, despite U.S. equities making up only ~60% of global equity markets.¹

Investors may be tempted to stick near home and invest in “what they know.” Equity markets have rewarded U.S. investors with home country biases in their portfolios for much of the past 15 years; however, when looking over longer periods, we know that this is not always the case. U.S. markets have also underperformed their international peers for long stretches of time (e.g., 2002 through 2007).

Individual investors may be questioning why bother allocating to international equities – especially when they’ve seen U.S. equities outperform their international peers over the past decade. Financial Professionals may be able to help clients build globally diversified portfolios by focusing on international companies that are more profitable, with lower leverage, and consistent earnings growth.

Quality investing seeks to invest in companies with strong balance sheets and higher profitability. In the current “higher for longer” rate environment we find ourselves in, finding companies with lower leverage may be attractive. BlackRock has seen strong interest in quality ETFs so far in 2023, with almost $12bn in inflows YTD as investors have looked for companies with lower levels of debt.² While a majority of the inflows have been into U.S. quality, advisors may also want to consider adding some quality exposure in their international sleeves. International quality’s performance has been even more persistent than quality in the U.S..

For advisors working with clients who are more averse to international investing given recent performance, using an international equity ETF that targets higher quality companies, may make investing abroad more palatable, while also adding exposure to a historically rewarded driver of returns.

Investors may be able to reap the potential benefits of investing in factors by sticking with their long-term strategic allocations. Many times, it is most difficult to stay invested in stocks or individual factors after periods of challenging performance. Financial Professionals have the ability to educate individual clients about the long-term benefits of factor investing as factors have rewarded investors that stay disciplined over time.

Factor performance tends to be cyclical. One factor can zig, while another zags. For long-term factor investors, balancing exposure to low or negatively correlated factors can help advisors ensure their clients stick with their asset allocation when one factor may fall out of favor.

We can use value as an example. Value investing seeks to buy companies that are cheap relative to their fundamentals. While value has been rewarded over time, it’s prone to periods of underperformance (like all factors). Adding in another rewarded factor that has low/negative correlations, can help advisors navigate periods that are challenging for value.

For example, quality tends to have low correlations to value. What may be more interesting to highlight is that when looking at over 30-years’ worth of data, international quality has actually provided even stronger diversification benefits compared to U.S. quality. International quality has been negatively correlated to value in the U.S., while also having low correlation to U.S. quality.

What’s the takeaway for advisors? Advisors may want to consider quality in U.S. and international markets as a way to diversify their clients’ portfolios. Financial Professionals with factor-based investment philosophies could consider not limiting their opportunity set to just factors within the U.S.. Expanding their toolkit to include factors internationally may give financial advisors the ability to build more robust portfolios for their clients – and more importantly, potentially help clients stick with their plans.

Given the strong relative returns we have seen in U.S. equities, some investors may question why they should even bother with stocks abroad. Many of these international companies may not be familiar names compared to the mega cap, U.S. domiciled companies they see in the news. Using an international quality ETF, like IQLT, the iShares MSCI Intl Quality Factor ETF, may be one way for advisors to increase allocations to companies abroad by focusing on companies with higher profits, low leverage, and more stable earnings growth.

Whether it’s a weakening U.S. dollar or stronger economic growth outside the U.S., adding exposure to international equities with higher quality characteristics may be prudent for today’s market.

There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.