What Component Mix Should Make Up Your International Equity Allocation?

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Several days ago, I shared an investigation on 1) the reasons/benefits of incorporating the international equity asset class in to your asset allocation and 2) the approximate optimal level in which to make the addition.

Essentially, the analysis of the ~40 year period between 1972-2011 revealed that holding 30% of your equity position in international stocks provides the highest return/risk ratio. This aligned very nicely with the advice from the literature saying that the optimal level is between 30-40% of your total equity allocation.

Having decided upon our optimal overall international equity allocation target, the question (that I want to investigate in today’s post) then becomes, “What type(s) of specific international funds or international sub-asset classes should make up this international equity allocation?”

Let’s take a look at answering this question, shall we?

What are Your Options for Components to Build Your International Equity Allocation?

The first step in trying to seek out an appropriate answer to this question is to figure out what international equity options are available to us in the first place.

For me, I personally like to keep the bulk of my investments in Vanguard index mutual funds. If we visit Vanguard’s mutual fund website and narrow the selection to International Index Funds, the following equity choices are displayed:

At first glance, the list above looks a little bit overwhelming. So many choices to pick from, right?!

Dissecting through this list of options a little more, I decided to rule out the total world stock index fund because it invests in US companies, which we are trying to get away from by investing internationally.

The next confusing aspect we have on this list is that we have a total international stock index fund and an FTSE all-world ex-US index fund. A common question that people ask is, “What makes these two international funds different?” It’s very reasonable to ask this question because at first glance, they appear to be the same type of non-US equity index fund. In general, one can assume that the total international index fund is the better choice because 1) it has a lower expense ratio and 2) is more broadly diversified because it includes not only large and mid (like the FTSE fund), but also small-cap international stocks as well.

Having removed these two funds for the reasons mentioned above from our list, let’s proceed…


Before I jump in to a long-winded investigation/discussion of my own, I generally like to share any relevant advice from people that are much more qualified than myself. Listed below is what I could find in the literature about deciding what sort of components should make up your international equity allocation:
  • Larry Swedroe (probably my favorite investing author I have found to date)
    • In his newer 2010 book, The Only Guide You’ll Ever Need for the Right Financial Plan, Larry mentions that emerging market equities, while being more volatile, also provide a higher expected return and a low correlation of returns with both domestic and international developed equities. Because of the low correlation, an investor should only hold enough so that he or she does not introduce tracking error to their portfolio. He then proceeds to recommend that an investor hold no more than 10% of their equity position in emerging market equities because doing so could increase the overall portfolio volatility above tolerable levels. Lastly, he mentions that the correlation of emerging markets to other equities increase during times of turmoil.
    • In Larry’s books, What Wall-Street Doesn’t Want You to Know and The Only Guide to a Winning Investment Strategy You’ll Ever Need, Swedroe provides an example portfolio with the following recommendations for international stocks as a % of your total equity position – 10% large value, 5% small, 10% small value, 5% emerging markets.
  • Burton Malkiel
    • In his famous and amazing book, A Random Walk Down Wall Street, Malkiel recommends an international equity allocation consisting of a 2:1 ratio of developed international markets to emerging markets.
  • William Bernstein (my 2nd favorite investing author I have found to date)
    • In his 2002 book, The Four Pillars of Investing, Bernstein recommends an international equity allocation consisting of a 1:1:1:1 split among European, Pacific, emerging markets, and international value stocks. This perspective was approximately echoed in his 2001 book, The Intelligent Asset Allocator, as well.
  • Rick Ferri
    • In his book, All About Asset Allocation, Rick provides what is in my opinion, the most complete explanation of how to slice and dice among international equity components. 
    • He recommends a 1:1:1:1:1 split between Pacific, European, international value, international small cap, and emerging market equities.

Conclusions from the literature – From the books written by the four authors above (some of the best on asset allocation I have found to date), it’s obvious that there is not consistent agreement as to the optimal international equity allocation split. 

However, for me, one clear conclusion is that I need to be careful with how much emerging markets equity I load in to my portfolio (keeping in mind the 10% of equity limit mentioned by Larry Swedroe perhaps), since this is clearly an asset class that can be quite volatile. In addition, there seems to be a a trend that the experts like to invest in region-specific index funds instead of just owning a fund that represents everything. This could be an important thing to investigate.

Which International Equity Components Recommended in the Literature Are Possible?

Since I like to invest with Vanguard (and they unfortunately do not have all of the mutual funds in the world), I am limited to the index funds that they offer. In this case, Vanguard does not currently offer an international large-cap value or small-cap value index fund. Therefore, we can scratch those international asset categories off of our list for consideration.

So, that leaves us with the remaining Vanguard funds shown below. In order to move forward, the next thing we need to figure out is what each of these funds invests in/represents. To this end, I’ve listed the allocation of each fund below as well.

  • Developed Markets Index, Ticker Symbol VDMIX (Intl Dev)
    • 64% Europe, 36% Pacific. 
    • Developed foreign markets in Europe and the Pacific only.
  • Emerging Markets Stock Index, Ticker Symbol VEIEX (EM)
    • Emerging markets only around the entire world (100%).
  • European Stock Index, Ticker Symbol VEURX (Europe)
    • 100% Europe developed markets (no emerging markets).
  • FTSE All-World ex-US Small-Cap Index , Ticker Symbol VFSVX (Intl Small(has the highest expense ratio (0.45%) of any Vanguard index fund I could find, so this is a pricey one to hold!).
    • Small-cap companies only around the world, both emerging and developed markets. 
    • 22% emerging markets, 39% Europe, 25% Pacific, 14% North America, 0.3% Middle East.
  • Pacific Stock Index, Ticker Symbol VPACX (Pacific)
    • 99% Pacific developed markets (mostly consisting of Japan and Australia), 0.7% Pacific emerging markets.
  • Total International Stock Index, Ticker Symbol VGTSX (Total Intl)
    • Represents the market weightings of the entire ex-US world, both developed and emerging markets, in the percentages shown below.
    • 19% emerging markets, 44% Europe, 29% Pacific, 0.4% Middle East, 7.7% North America.

Having listed out this information, I then was curious to see what type of performance these 6 asset classes have had over the past 40 years or so. To do this, I again used the 1972-2011 data from Simba’s backtesting spreadsheet from the Bogleheads.org forums.

The average annual return, standard deviation of annual returns, and return/standard deviation ratios are shown in the table below for each asset class. In the table below, I have also listed the data for the Total US Stock Market Index (MKT-TSM) for comparison as well.

There are several interesting findings from this table above.

  • We see that the emerging market and international small-cap asset classes provided a MUCH MUCH MUCH higher average return than the other asset classes, as we might expect, given the significant increase in risk associated with these asset classes.
  • The return/standard deviation ratio for the emerging markets and international small-cap asset classes is on par with that delivered by the total US stock market, so those asset classes provide some nice opportunity for increasing returns, provided that one can stomach the increased risk.
  • The Pacific equity asset class provided the least-efficient ratio of return/risk.
I think the risk and return associated with these various international equity asset classes are also nicely shown graphically as well. Shown below is a graph of the hypothetical growth of a $10,000 initial investment in the 7 asset classes shown above over the past 40 years. 
Just take a look at how much higher return the (green line) emerging market fund delivered – almost 10x higher ending value than the total international fund! However, that higher return came at the expense of increased risk. Look at 2007-2008. The emerging market fund lost 50% of its value! 

Question # 1 – Is it Worthwhile to Hold Individual Region-Specific Developed Market Index Funds?

After looking at the return data above for 1972-2011 and also reviewing what is in the literature, I still was left questioning whether or not it is actually beneficially to hold region-specific developed market funds (so for Europe and the Pacific area). Or, would I be about as well off if I simplified it all and purchased just one fund that represents everything?

In his book mentioned in the literature section above, Rick Ferri provides a wonderful argument for why it is in fact better for investors to hold index funds of individual developed market regions (Europe and Pacific) vs one that represents the entire class. The reason for this he describes is that the weight of the various regions can vary GREATLY  depending on the market conditions around the world. For example, over the past 40 years, the majority stake of the developed market index has swung 3 times between the Pacific and European regions. He suggests that instead of depending on a total market fund, which is subject to these fluctuations, it is more efficient for an individual to hold a consistent equal weighting of developed market equity in Pacific and European regional index funds.

To test out Rick’s hypothesis, I back tested the performance of two portfolios over the past ~40 years, one consisting of 100% the International Developed Market Index Fund, and another carrying a constant 50/50 split between the Pacific and Europe regions (the regions that make up the Developed Market Index Fund). The results are shown in the graph below.

As you can clearly see, the 50/50 split portfolio (blue line) between Pacific and European regions outperformed the 100% international developed portfolio by a good margin over the time period analyzed.

The table below shows the exact average annual return and standard deviation (risk) data from this analysis. As you can see in the table, the 50/50 portfolio provides a more efficient (higher) ratio of return/standard deviation, indicating the there is in fact a benefit to investing in region-specific index funds.

Conclusion/Answer to Question # 1 – Yes, it does seem to be worthwhile to invest in region-specific index funds (in a 50/50 ratio in Pacific and European index funds) to gain developed market equity representation.

Even though this split does not give us exposure to Canada, we’ll ignore this deficiency for the time being and continue on with the investigation…

Side note: I’m not sure why, but there’s just something that I don’t personally favor with the idea of investing in a region-specific index fund versus a total international market fund. It seems like investing in just two regions would somehow exclude some areas of the world…However, more on this preference later! 

Question # 2 – Should Emerging Markets and/or International Small-Cap Index Funds Be Incorporated?

From the investigation above, we now know how to assemble the developed market mix of our international equity portfolio using the Pacific and European regional index funds.

However, what do we do with the more volatile and higher-returning international small-cap and emerging market asset classes? Do we add them to our portfolio? And if so, how does it work incorporating them in with general developed market equities?

In order to seek out some sort of answers for these questions, I back tested an international equity portfolio consisting of 25% Europe, 25% Pacific, and then varying amounts of Emerging Markets and International Small-Cap equities to complete the portfolio (time period was again 1972-2011). The average return and standard deviation results can be seen in the table below:

What we can observe in this table is a little bit surprising. When we add increasing amounts of the international small cap asset class, the volatility does decrease, but it does so slower than the accompanying decrease in return. What this means is that adding international small cap equity does NOT make our portfolio significantly more efficient.

Because of this finding and the fact that the International Small-Cap Equity Index Fund carries such a high expense ratio, I do not think it is worthwhile to add to my portfolio at this time.

However, this data does clearly dictate the the inclusion of emerging markets is quite important!

Conclusion/Answer to Question # 2 – Including emerging market equity seems to be very significant in increasing returns and efficiency of an international equity portfolio. The addition of international small-cap equity seems much less important / potentially not worth the cost of owning that asset class.

Having answered this, let’s explore the action of including emerging markets a little further.

Question # 3 – Does the Incorporation/Balance of Emerging Markets Control International Equity Portfolio Construction?

Because of the dominating effect that the inclusion of emerging market equities had over international small-cap equities in the investigation in the previous section, I then hypothesized the following:

Hypothesis/Question: If I incorporate a significant level of emerging market stocks in to my international equity allocation, will the dominating effect make it less important to worry about buying region-specific funds (something against my personal preference)?

Essentially, what I’m thinking is that if I just incorporate emerging market equity in to my international stock portfolio, I could just simplify everything and complete my international portfolio with a total international stock index fund. This type of fund would also provide coverage of Canada as well, which is also a plus!

To see if I could validate my hypothesis, I back tested the 3 international equity portfolios described in the bullets below during the common time period of 1972-2011. For my emerging markets allocation, I used the optimal 50% emerging market level found in the Question # 2 section above and filled the remainder of the portfolio with developed, region-specific, or total international market funds. The performance results can be seen on the graph below:

  • Green Line – Portfolio consisting of 25% Pacific, 25% Europe, and 50% emerging markets.
  • Blue Line – Portfolio consisting of 50% international developed equity and 50% emerging markets. 
  • Red Line – Portfolio consisting of 50% total international market equity index and 50% emerging markets.

The graph above reveals something fairly intriguing. In fact, what we see is that the green and red lines are essentially overlapped, indicating that there isn’t much difference between holding half of your international equities allocation in a total international fund vs. investing in separate Pacific and European region-specific funds. However, you do get a significantly less efficient portfolio if you were to use a developed market index fund over a total international fund.

To add some definite numbers to the performance seen in the graph above, I assembled the return data in the table below:

Looking at this data provides us with some form of an answer to Question # 3 –

  • The amount of emerging market equity essentially drives the performance/returns of an international equity portfolio. 
  • There is not much difference between using a total international index fund vs. Pacific and European region-specific to gain representation for the developed international markets.

Putting it All Together – Defining What Split You Should Maintain Between International Developed and Emerging Markets

To recap, so far, we have essentially seen that the most important decision to make when investing in international equities is to define a mix you’re comfortable with between emerging and developed markets. How exactly you decide to represent the developed markets carries less of an overall effect.

So, what is the optimal % that emerging market stocks should represent in your international equity portfolio? 

It’s an intriguing question. Let’s take a look!

In order to put in to context everything that has been covered in this post and the post from several days ago that investigated the optimal overall international equity allocation to carry, I modeled various portfolios consisting of 30% short-term treasuries and 70% equity from 1972-2011. The equity portion of the portfolios consisted of a constant split of 70% total US stock market and 30% international equities. Finally, inside the international equity sub-allocation, I modeled the average annual returns and volatility (standard deviation) that would have resulted using increasing amount of emerging market stocks, ranging from 0-100% of the international equity sub-allocation. The total international market index was used to fill the remainder of the international equity portfolio.

The results of this investigation can be seen in the return/risk graph below (each point represents an additional emerging market allocation of 10%). Let’s start on the left side of this graph, where we have no emerging market stocks. As we might expect from the risk/return trade off, we obtain increasing amounts of return as we add increasing amount of emerging market stocks.

To go along with this, it’s also beneficial to examine the real numbers that were used to construct the above graph. This data can be seen in the table below.

In my opinion, the two most important and useful columns of this table are the last two – the one showing the average return / standard deviation ratio and the one showing the slope of the return/risk curve. 

What we see when we examine the return / risk ratio column is that the portfolio that is numerically the most the efficient is the one whose international equity allocation consists entirely (100%) of emerging market stocks. However, in portfolio construction, the most efficient allocation is useful unless an investor can actually stick with it for a very long time.

Because of this, the short/easy answer to the question of how much emerging market exposure to carry is basically, buy as much as you can sleep well at night holding.

However, a more practical answer to this question can also be obtained by examining the last column of the table, showing the slope of the return / risk curve. Essentially, what this column is showing us is how much increase in return we get per unit increase in risk. Because of how the slope is calculated, a HIGHER slope number is better for us as investors.

Keeping this in mind, we see on the table that the slope of the return curve is highest between the range of 0-20% emerging markets (as a % of international equity holdings). What this means is that we definitely want to have around 20% emerging markets in our international equity portfolio to take advantage of this benefit.

When we add more emerging market stocks (between 30-50%), the slope is pretty much constant, albeit less than it was between 0-20%. When you add emerging markets to above the 50% level, there is another significant decrease in the curve’s slope. 

So, my overall takeaway from this analysis is that we want to take advantage of the slope of the risk return curve by holding a minimum of 20% and a maximum of 50% of our international equity position in emerging market stocks. Aside from the mathematics of this, I think that going above 50% emerging markets might cause tracking error for most investors.

If you’re interested in checking out all of the detailed calculations/numbers I used for the back testing in this post, click here to visit the Google Docs Spreadsheet.


So, after going through all of this investigation comparing varying mixtures of international equity asset classes, what’s the overall verdict? Well, I think it can be summed up in a couple of key-points:

  • Figuring out which specific components to use to build your international equity portfolio can produce quite a headache because of the varying opinions among experts in the literature, confusing terminology in figuring out what assets international mutual funds hold, and common lack of low-cost options to normal investors.
  • It is more efficient to gain exposure to international developed markets by investing in region-specific Pacific and European index funds vs. simply holding a developed market index fund that represents everything.
  • However, the incorporation of the emerging market asset class is much more significant as far as driving portfolio behavior than the decision of whether or not to use region-specific developed market funds.
  • By examining the behavior of incorporating emerging market equities in a complete 70/30 equity-fixed income portfolio, we see that investors should take on as much emerging market exposure as they can (within their international equity allocation of course!) without incurring tracking error. 
    • However, the most significant contributions to increasing portfolio return while only marginally increasing risk occur by having 20-50% of your international equity allocation in emerging stocks.

In the interest of putting a personal application to this topic, I wanted to share how this investigation applies to me. I currently use a 70/30 equity-fixed income asset allocation split in my portfolio. Of the equity position, 70% is dedicated to US Market, and 30% is International exposure. Within my international equity exposure, 52% is invested is emerging market equity, and the other 48% is invested in a total international market index fund. So, I’m luckily already aligned with what was found to be the pretty efficient as far as the slope of the return curve went from the 40 year analysis in the last section which looked at the level of emerging market exposure to have. 

Path Forward – For me personally, there are three things that I could “technically” improve upon in my portfolio from what we saw in this analysis. However, none of them are convincing enough right now for me to make any changes. 

  • First, I could technically improve the efficiency of my portfolio by adding a small amount of International Small Cap stocks (~5% of my international portfolio).
    • However, that would only add up to be 1% of my total portfolio, which is in my mind, too small of an amount to bother with and to pay the 0.45% expense ratio for.
    • Therefore, I don’t think I will add any small-cal international stocks to my portfolio at this time.
  • Second, I could technically increase the efficiency and return of my portfolio by increasing my exposure to emerging market stocks above 50% of my international equity portfolio. 
    • However, I feel that adding more might expose me to some tracking error, and the total international stock index fund I owe also already has exposure to 20% emerging markets as well.
    • So, I’m going to stick with my current emerging markets allocation at this time.
  • Third, I could technically make my portfolio marginally more efficient by investing in Europe and Pacific region funds. 
    • However, this just seems like it would be more complex than needed for the marginally improvement, since I already have incorporated emerging market equities in to my portfolio which mostly drive the international equity return.
    • In addition, I like that the Total International Index Fund gives me a little broader market exposure by including Canada.

How about you all? What type of component mix do you have in your international equity portfolio allocation?

Are there any potential changes you are thinking of making any time soon?

Share your experiences by commenting below!


  1. Thanks for the excellent analysis! I was just thinking about these question myself and now you saved me the trouble of trying to do my own analysis.

    I do own some International Small Cap in the form of Vanguard FTSE All-World ex-US Small-Cap ETF (VSS) which only has a 0.25% expense ratio.
    My recent post Book Review: The Intelligent Asset Allocator

    • Thanks for always being a fan of my asset allocation analysis posts rjack!

      That's great to hear that the intl small cap etf has such a low expense ratio! Normally, they are only about 0.1% lower than than the corresponding mutual fund, but that is a full 0.2% lower! nice!

      Does vanguard have any international value etf's yet?
      My recent post Fedex, UPS, or USPS – Which is the Best Option for Mailing Packages?

  2. Unfortunately, Vanguard does not have any international value etfs.
    My recent post Book Review: The Intelligent Asset Allocator

    • OK that's what I was thinking based on the mutual funds they offer, but you never know with how popular ETFs are these days!
      My recent post Fedex, UPS, or USPS – Which is the Best Option for Mailing Packages?

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