The trend toward “passive” investing – by which I mean investing in low-cost index-type funds that own broad swathes of the investable marketplace – is certainly a phenomenon that has many more years to play out.  Investors, frustrated with the high costs of actively managed funds, have shifted billions of dollars in assets from active funds to passive funds, and they have done so somewhat indiscriminately.

From an American investor’s point of view, the logic is simple:  if you can’t beat it, own it.  Based on the well-documented futility of most active managers to beat the S&P 500 index on a consistent basis, this conclusion is reasonable.  After all, why pay more for less?

One reason why indexing makes a lot of sense when it comes to U.S. equities is that returns across almost all sectors have been very strong, with few lagging sectors and industries.  Even though certain sectors were fairly volatile, the periods of negative returns were relatively uniform across the board.  In other words, with the rather strange exception of telecommunications, there was not much opportunity cost associated with being long one industry and avoiding another:

Foreign Stocks

The same, however, cannot be said of global equities, by which I mean the broad universe of developed market shares outside the United States [Note:  I use the MSCI EAFE Index as it has a longer track record than MSCI All World ex-US.  They track fairly closely, anyway.]

Foreign Stocks

As one can see, there were serious variations in returns from one industry to another.  There are perhaps several reasons for this:  Over the period observed, the U.S. dollar was strong more often than it was not, so foreign returns quoted in dollar terms would naturally be more scattered.   There is also the possibility that the two most profitable sectors, consumer staples and healthcare, are simply reflecting strength in the overall Swiss market, the large companies of which account for large chunks of those two sectors.

Whatever the case, an investor, when making the decision to allocate resources abroad, must first ask himself why is it that he is doing so?  Is it because valuations are more favorable?  Is it because there are opportunities that do not exist domestically?  Or, most likely, is it simply to diversify one’s portfolio away from U.S. assets in general, and to hedge against dollar weakness in particular?

If it is the first reason, the case can be made – and I have made it – that relatively favorable foreign equity valuations are merely the product of index construction.  Sector versus sector comparisons somewhat easily dispel this myth, but I have beaten this particular horse to death, so I will leave it at that.  Regarding the second question of lack of opportunities in the United States, I would say that this is also patently untrue; in many other foreign markets, such as Brazil, the best companies are private and closed to investors.  Investment opportunities in the United States abound to the extent that no other market can come close to matching it.  That leaves us with the goal of diversification, and it is this reason – and this reason only – that I feel is the only really compelling reason to invest abroad.

We know that a good deal of the outperformance of foreign versus domestic equities comes during periods of dollar weakness.  Again, I have written several times about this topic, so there is little point in revisiting it in detail here, but let us just accept this as an established fact.  That being said, one might reasonably expect that an investor worried about dollar weakness might benefit more from owning the much more volatile shares of foreign banks than he would from the much more stable global consumer staples sector.  Yet the relative returns of foreign versus American financials (Graphic 1) across dollar cycles are only slightly more favorable than that of foreign consumer staples versus their American counterparts (Graphic 2):

Graphic 1:

Foreign Stocks

Graphic 2:

Foreign Stocks

As can be seen from the scatterplots, an investor in foreign banks would have received a negligible advantage during periods of dollar weakness while having to stomach almost twice the volatility than an investor in consumer staples.  Furthemore, over the full period observed, the returns of foreign consumer staples were less correlated with American consumer staples than were the returns of foreign and American financial stocks:

Foreign Stocks

In fact, with the exceptions of telecommunications and utilities, – the low correlations of which can be explained by the vast regulatory differences between them and their U.S. equals, – a good portion of the foreign marketplace traded more or less in lockstep with their U.S. equivalents.

A good way to put this in perspective is to look at the energy sector.  All energy companies peddle almost indistinguishable products, and they are all subject to the same macroeconomic headwinds.  So what would be the appeal of foreign energy shares to an American investor who already has domestic energy exposure, especially when there is 87% correlation between the two, never mind the fact that domestic energy companies have pretty well outpaced the foreign competition?

In my opinion, investors looking to allocate abroad need to consider the foreign marketplace almost like a sports executive would treat a field of eligible draftees:  do you take what you need (for example, a known hole in your portfolio’s allocation) at a given position, or do you take the best player (in this case, company) available?  I would argue the latter.  In most major industries around the world, particularly those such as financials and utilities that are deemed vital to the economy, the difference between their profitability and their U.S. counterparts is likely to be vast.  They exist not to enrich shareholders but to fulfill a vital function in society.  That is admirable from a social perspective, but it is not a great investment thesis.  In marked contrast, foreign healthcare and consumer staples companies such as Nestle and Bayer are truly global brands with strong positions in just about every market around the world.  They are every bit as well-run as American companies of the same type, and their track record in a weak cycle for foreign stocks bears that out.

I am certainly not advocating that investors become stock pickers, or pile into just one or two foreign industries.  Rather, I am suggesting that investors be more aware of what they own and why they own it, and make sure that it is actually consistent with their investment theses.  Foreign investing is quite a bit more difficult than investing domestically, and investors used to the cruise control of indexing may be in for an unpleasant surprise if or when they should discover, as I think they will, that this strategy may not apply so well overseas.

This article first appeared on http://www.fortunefinancialadvisors.com