Investing in international equities: Why look abroad?

International equities have broken a long stretch of underperformance versus U.S. equities in the first half of 2025. U.S. equities are slightly positive year to date as of May 28 according to the S&P 500 Index, while international equities are up about 15% using the MSCI ACWI ex-USA Index as a reference.

That performance difference is made more remarkable by the fact that international equities remain considerably less expensive than their U.S peers on a price-to-earnings basis—only slightly narrowing a valuation gap that has been widening for most of the last decade.

Exhibit 1: International equities are less expensive than their U.S. peers, but are they a bargain?

Source: FactSet. Data shown for period from 1/29/2016 to 5/23/2025.

Over the past ten years, investors have grown accustomed to U.S. primacy in equity markets as international equities trailed the U.S. by 7.5% annualized during the period.¹ The diversification benefit of investing abroad for U.S. investors has also seemed to diminish over time. Exhibit 2 shows the correlation between the S&P 500 and MSCI ACWI ex-USA.² This longer-term trend suggests that overseas equities have moved more in tandem with U.S. equities, potentially lowering their value as a portfolio diversifier.

Exhibit 2: A questionable portfolio diversifier for U.S. investors
Rolling one-year correlation between the S&P 500 and MSCI ACWI ex-USA

Source: FactSet. Data shown for period from 1/29/1988 to 3/31/2025.Trailing one-year periods as of each month end.

Based on the performance reversal during the first half of 2025 and questions about their portfolio diversification benefit, should investors think about international equity markets in a different light?

We believe international equities deserve a place within the long-term strategic allocations of most equity investors. However, we caution against investing passively in an index. Instead, we believe investing abroad should be done at a fundamental level where the emphasis is on finding fund managers whose process leads to companies that offer four key features: 

1. earnings growth comparable to levels found in the U.S.
2. quality-like attributes, such as above-average returns on equity and attractive reinvestment opportunities 
3. unique, durable sources of demand responsible for earnings growth
4. reasonable valuations

How can profitability help explain the difference between U.S. and international equities?

Return on equity (ROE) shows how well a company (or index) uses resources to generate income. We believe that an investor’s return over time will likely look similar to that company’s (or index’s) ROE, assuming a change in the company’s valuation doesn’t distort the relationship by growing more or less expensive during the timeframe. In technical terms, ROE measures the financial performance of a stock by dividing its net income by shareholders' equity. Simply put, ROE can be a helpful indicator for determining potential performance.

With that in mind, exhibit 3 compares the trailing twelve-month ROE of the S&P 500 Index with the MSCI ACWI ex-USA Index since January of 2016.

Exhibit 3: U.S. stocks outperformed overseas stocks
Return on equity for S&P 500 and MSCI ACWI ex-USA

Source: FactSet, as of 3/31/2025. Return on equity shown on a trailing last 12-month basis.

On average over the decade through March of 2025, the ROE for the S&P 500 was 16%, and its annualized return was 12.5%.³ For the MSCI ACWI ex-USA, its average ROE for that time period was 11% while its annualized return was 5%.⁴

All of this is to say that, in general, the S&P 500 and the MSCI ACWI ex-USA have largely earned their returns, meaning that their corporate earnings have justified these indexes’ respective performances. U.S. companies have outperformed their offshore peers, and we believe the difference in performance between the two indexes can be attributed to the differences in ROE. It is the persistently lower ROE of the international index that leads us to shy away from investing at an index level in overseas markets.

But are there diamonds in the rough?
Amongst the 1,800-plus companies in the MSCI ACWI ex-USA, might there be companies worth owning? Are there companies potentially capable of generating ROEs like what we find in the U.S.?

To answer these questions, we added a third line to exhibit 4 which shows the ROE of the MSCI World ex USA Sector Neutral Quality Index. It’s composed of companies that have demonstrated high ROEs, low leverage ratios⁵ and consistency in earnings. The selected 300 or so companies were then weighted to match the sector allocations of the MSCI ACWI ex-USA Index.

Exhibit 4: Overseas quality stocks look similar to their U.S. peers
Return on equity for S&P 500, MSCI ACWI ex-USA and MSCI World ex USA Sector Neutral Quality Index