International Funds: Diversifying Beyond US Borders
International funds invest in stocks and bonds outside the investor's home country. A 100% US stock portfolio returned 12.4% annually from 2010 to 2024, while a 60% US / 40% international portfolio returned 9.8% — but international outperformed US stocks in 5 of the last 7 decades.
International diversification is one of the most debated topics in investing. From 2010 to 2024, US stocks dramatically outperformed international stocks — the S&P 500 returned 12.4% annually while the MSCI EAFE (developed international) returned 5.8% and the MSCI Emerging Markets returned 3.5%. This has led many investors to conclude that international stocks are not worth holding. But this period is the exception, not the rule. From 1970 to 2009, US and international stocks took turns leading — international outperformed in the 1970s, 1980s, and 2000s. From 2000 to 2009, the S&P 500 lost 9.1% while the MSCI EAFE gained 1.2%. The 2010s were the anomaly of a single country (US) dominating global markets.
Vanguard's research on the optimal international allocation shows that a 20% to 40% allocation provides most of the diversification benefit without excessive currency risk or tracking error. Holdings above 40% add minimal diversification benefit while increasing currency volatility. The key reason to hold international stocks is that the US stock market represents about 60% of global equity market capitalization. If you own only US stocks, you are betting that the US will continue to outperform the other 40% of the global market — a bet that has historically been profitable for US investors but is far from guaranteed. Japan's stock market represented 45% of global market cap in 1989 but fell to 8% by 2020. US investors who held only US stocks in the 1980s missed the Japanese boom. Japanese investors who held only Japanese stocks lost a generation of wealth after 1989.
Real-world example: Vanguard Total International Stock Index Fund (VTIAX) holds approximately 8,000 stocks across 45+ countries. Its largest holdings include Nestlé, Taiwan Semiconductor Manufacturing, Tencent, Novo Nordisk, and Samsung. The fund returned -14% in 2022 and +15% in 2023. Over the full 2010 to 2024 period, its 5.5% annualized return significantly lagged VTSAX's 12.4%, but a 20% to 40% international allocation reduced portfolio volatility by approximately 0.5% to 1.0% annually.
Currency Risk and Hedging
Investing internationally introduces currency risk. When you buy a foreign stock, your return is the stock's local return plus the change in the exchange rate. If the US dollar strengthens, international investments lose value in dollar terms even if the underlying stocks perform well. From 2014 to 2016, the US dollar strengthened 20% against major currencies, wiping out international stock returns. From 2020 to 2022, the dollar strengthened 25%, again significantly dampening international returns. Currency-hedged international funds (like iShares Hedged MSCI EAFE ETF, HEFA) eliminate currency risk using forward contracts but add cost (0.30% to 0.50% expense ratio) and reduce diversification. For long-term investors, unhedged funds are generally preferred — currency fluctuations are zero-sum over long periods and the cost of hedging erodes returns.
FAQs
How much of my portfolio should be in international stocks?
Vanguard recommends 40% of equities in international stocks, matching global market cap weight. Fidelity recommends 30% to 40%. Warren Buffett recommends 0% — he says US stocks are sufficient for US investors. Bogle recommended 0% to 20%. The optimal allocation depends on your conviction and ability to hold through periods of underperformance. The most important thing is to choose an allocation and maintain it regardless of recent performance. If you cannot tolerate watching international funds lag US funds for years, a 20% allocation is better than 40% because you will not abandon the strategy during a drawdown.
Should I invest in emerging markets separately?
Emerging markets (China, India, Brazil, Taiwan, South Korea) offer higher growth potential but higher volatility and higher political risk. The Vanguard FTSE Emerging Markets ETF (VWO) has returned about 4% annually over the past decade — roughly comparable to developed international. Rather than overweighting emerging markets separately, you can use a total international fund which holds both developed and emerging markets at market weight. VXUS (Vanguard Total International Stock ETF) holds about 75% developed and 25% emerging markets. Overweighting emerging markets is a high-risk bet that has not paid off for most investors.
How are international fund dividends taxed?
Dividends from international funds are generally taxed as ordinary income, though some qualify for the lower qualified dividend rate if the foreign corporation meets certain criteria. The foreign taxes paid by the fund are passed through to shareholders as a foreign tax credit. Form 1099-DIV reports the foreign tax paid in Box 6. You claim the foreign tax credit on Form 1116 (or a simplified version if foreign taxes are under $600). In 2023, VXUS paid approximately $0.04 per share in foreign taxes on dividends of $0.75 per share — about 5% of the dividend. The foreign tax credit offsets US tax dollar-for-dollar, effectively reducing double taxation on international investments.