“U.S. stocks have absolutely destroyed the competition over the past decade, but that’s not always the case,” says Charles Sizemore, a portfolio manager at Boston-based Interactive Brokers Asset Management, and principal of Sizemore Capital in Dallas.

He’s talking about a growing interest in international equities, particularly among holders of variable annuities (VAs). “It only makes sense,” Sizemore continues, “that variable annuity providers would want to make international markets available [to clients]. There will come another time, and probably soon, when international stocks will outperform for a sustained period of time, and this gives the variable annuity participants access.”

The use of international investments within VAs may not be exactly news. At least it isn’t to Michael Kitces, a partner and director of wealth management at Columbia, Md.-based Pinnacle Advisory Group. “This is nothing new,” he says. “I was using variable annuities with international subaccounts 17 years ago when I started my career. As long as there have been international mutual funds, there have been international subaccount options in variable annuities.”

The reasons, he goes on, are manifold. Advisors use international funds for the diversification reasons in all sorts of accounts. “The fact that they are inside of an annuity wrapper, instead of a brokerage account or an IRA, is usually just incidental,” Kitces says.

Improved Diversity In VA Subaccounts

Yet the number and variety of international subaccounts does seem to be on the rise. Clients want choices. If there’s an increasing number of VAs with international exposure, that’s part of a broader trend of growth in the range of VA subaccounts available.

“Recently, annuities have begun to offer more diversified international funds,” says Rick Leyva, a senior partner and managing director in the LDR International Group at San Diego’s Snowden Lane Partners. “Prior to the financial crisis, their mutual fund offerings and models were U.S.-market-centric with less than 10% exposure to foreign markets (and usually with unpopular international funds), while currently they are still overweight domestic managers but have also introduced best-in-class international managers with both equity and fixed-income offerings.”

Laurence Greenberg, president of Louisville, Ky.-based annuity provider Jefferson National, which operates as Nationwide’s advisory solutions business, confirms the trend. Citing data from Morningstar, he says, “Roughly 2,200 variable annuity products are currently available to investors. While a very small number of VAs offer more than 25 international and global funds, roughly half of all VAs offer 10 to 25 international and global funds.”

Last year, he says, those funds represented some 11% of total assets under management within U.S. variable annuities—or nearly double the dollar amount in such funds back in 2010.

Too Risky For Retirement?

Some critics might point out that investing in international markets can be risky, especially for an investment such as an annuity that’s supposed to provide guaranteed income in retirement. While there’s a degree of truth in that, others insist that there’s actually less risk than there used to be.

“The subaccounts are typically [with] best-in-class asset managers with very respectable AUMs,” says Leyva. “They’re popular because they have long-term success. … Advisors are interested in presenting [to clients] annuities with good performance potential.”

Lately, there’s been some potentially compelling performance data. Consider this: In the first three quarters of 2017, while the benchmark S&P 500 gained nearly 13%, equities in the euro-using countries measured by MSCI outpaced the U.S. index by some 10 percentage points. Meanwhile, in the emerging BRIC nations (Brazil, Russia, India and China), equity markets skyrocketed almost 31%.

A fluke, perhaps. Water under the bridge, definitely. But these are just some reasons investors might prefer international stocks over U.S. counterparts, even if it’s through VAs.

Nevertheless, a degree of caution is not unwarranted. “By themselves, international and emerging markets subaccounts are riskier than U.S. equities, due to additional currency and geopolitical risks,” says Chuck Bean, founder and CEO of Heritage Financial Services in Westwood, Mass. “However, strong demographic trends and higher GDP growth in many countries outside the U.S. can offer valuable investment opportunities within a well-allocated portfolio.”

Portfolio Balancing and Rebalancing

He notes that VAs with international investments should be rebalanced periodically. “At retirement, when the investor is looking for income,” says Bean, “this portion of the portfolio should be a modest component of a larger overall investment plan.”

Generally speaking, whether internationally or domestically invested, VAs are not right for everyone. “Variable annuities should only be considered after the investor has maximized contributions to his or her employer-sponsored retirement plan and IRAs,” notes Bean. “If the time horizon is long enough, and they’re in a high tax bracket looking to reduce current income taxes on their non-retirement investment money, low-cost variable annuities can be a good choice.”

Bean only considers low-cost, fee-based VAs that have “no back end charges or extra fees,” he says.

Sizemore agrees. “Clients are more sensitive about fees these days, as they should be,” he says. “So you really have to be careful with all variable annuities, whether international or domestically focused. If your clients are paying a high fee or have a long surrender period, then they had better be getting a lot of value out of it.”

Sizemore prefers what he calls “RIA-friendly annuities” with “low fees, short or nonexistent surrender periods and no up-front commissions,” he says. “Personally, those are the only annuities I would touch.”

The VA Wrapper As Volatility Hedge

Still, some market participants suggest that holding international securities within a VA wrapper can actually be a safer way to go. “Advisors and investors are wary about the long upward trend in the [U.S.] market,” says Kyle Shores, chief investment officer at Botsford Financial Group in Frisco, Texas. “Many believe the most growth potential left in the market is going to be in mainly non-U.S. based investments. However, because they are wary about how much longer this market can last, they are using the variable annuity to hedge.”

The thinking works like this, he says: If the market continues rising, international investments might be the biggest winners. But in the event of a downturn, international indexes will likely fall at least as much as their domestic counterparts. Since VAs limit the upside potential but also cushion against the downside risk, they work as a hedge against volatility.

“So do your international investing where your future income is not affected by the whims of the market,” he explains, adding that this allows stakeholders to “take risk and potentially be rewarded on the upside but protects what is really important: the income in a market correction.”

Diversification, An Old Idea

While that may be true, Michael Rosenberg, a registered financial consultant and managing director at Diversified Investment Strategies in Livingston, N.J., insists that basic diversification principles still apply. “The same diversification rules would apply within a VA as would apply outside a VA,” he says. Rosenberg typically diversifies his clients’ portfolios with some international exposure, “though the percentage of international is less the older a client is,” he says.

What is risky, he stresses, is not diversifying. “If you just own international alone, yes, [that would be] risky.” He notes that just slightly more than half of the world’s equity market is based in the U.S. “So by not diversifying through international exposure, you are losing exposure to almost half the [total] equity market.”

For advisors, then, the basic portfolio-building rules are as applicable to VAs as other investments. “Even though a client is in a VA, you still want to manage the investments to perform,” notes Rosenberg. “Thus, most advisors need to adhere to an approach that a diversified portfolio will provide lower volatility. … Though a specific asset might have a higher rate of return over time, the portfolio with lower volatility will have greater growth over time.”

Buffering Standard Deviations

Another way to look at it, says Rosenberg, is that this kind of diversification will reduce the holdings’ standard deviation. “When you have a portfolio that is taking withdrawals, it’s all about having a lower standard deviation,” he stresses. If two portfolios have the same return rate, whichever has the lower standard deviation will ultimately produce greater growth, he says. “One might say that a client is not taking a withdrawal; but remember, with fees somewhere between 3% and 4%, that by itself is a distribution,” says Rosenberg.

Needless to say, all investments should be carefully researched before they are recommended to clients. This may be especially true when international asset managers are involved. “If a fund has been approved by annuity actuaries for use in a product, then advisors should do their research on said manager,” says Snowden Lane’s Leyva. “In many instances, these managers are popular with international investors while remaining relatively unknown in the domestic marketplace.”

Indeed, finding such managers through a VA can be an advantage. “In many cases, direct access to these international managers is easier through the annuity product versus getting the fund approved by the firm’s due diligence team,” says Leyva.