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Most Investors Fail This Test

Let me give you a little test.

I’ll present you with the valuation metrics and dividend yields for two exchange-traded funds (ETFs).

Your job is to simply decide which ETF you’d prefer to hold as an investment for the next 10 years.

They’re both actively traded, but I’m not going to reveal their tickers. I’ll just call them X and Y.

As a bit of background, both funds have expense ratios below 0.15%, are diversified from a stock and sector perspective, and exclude small-cap stocks.

It’s a simple decision, so there’s no need to overthink it.

Here are the choices:

 Which one would you like to own for the long haul?

Cue the Final Jeopardy countdown music…

Ok, now it’s time to unveil the mystery funds.

ETF Y is the SPDR S&P 500 ETF Trust (SPY), the largest ETF in the world. Hopefully, the only reason you would have selected this one is because you made it too complicated and had a little game theory moment.

If you focused on the numbers alone, you should have gone with ETF X: the Vanguard FTSE All-World ex-US ETF (VEU).

VEU’s holdings are cheaper, on average, based on each valuation measure. It also has a higher dividend yield.

But here’s the real reason I’m bringing VEU to your attention…

Time to Shift Your Focus

You see, the true test is how much foreign exposure we have in our portfolios.

Most investors fail miserably when it comes to selecting an appropriate level of international diversification.

And VEU exclusively holds non-U.S. stocks.

Foreign developed and emerging nations, which are specifically the markets that VEU tracks, account for 55% of the world’s equity market capitalization. Judging from the metrics above, this is where bargain hunters should be looking to invest.

My colleague, Richard Robinson, recently examined some surprising values in global integrated oil stocks, and each has an excellent dividend yield as a kicker. His analysis corroborates the relative value of VEU seen in the table above.

Foreign stocks are currently less expensive because global equity markets move in cycles.

Back En Vogue

Just as designers bring back clothes that were fashionable decades ago, the financial markets experience long-term trends that bring markets in and out of favor.

U.S. equity indices have been outperforming most of their foreign counterparts for the better part of six years.

Think of the chart below as a time-series version of the snapshot in the ETF table above.

As you’ll notice, the ratio between the MSCI World ex-U.S. Index and the S&P 500 Index is now at a level not seen since the technology bubble, a period of ludicrous U.S. stock valuations.

Domestic valuations are certainly not as stretched as they were back in 1999-2000. Nonetheless, the relative valuation pendulum has swung in favor of foreign stocks.

However, few have noticed this change or have the fortitude to alter their investment strategies.

Being a contrarian is certainly not easy. You have to make decisions that feel uncomfortable at the time and defy conventional wisdom.

I withheld the names of the ETFs above because I didn’t want you to gravitate towards the familiar and comfortable U.S. markets.

Now is the perfect time to embrace foreign equities when determining our portfolio allocations. By doing so, we’ll be utilizing our primary advantage as investors – an extended time horizon.

Safe (and high-yield) investing,

Alan Gula, CFA