Why VSS Could Be the Most Overlooked Long-Term Diversifier in International Investing

International stocks have outperformed U.S. stocks over the past 12-16 months, with the MSCI ACWI ex US Index up about 40% over 12 months versus 36% for the Russell 3000, and 35% versus 17% over 16 months. The Vanguard FTSE All-World ex-US Small-Cap ETF (VSS) returned 30% in 2025 versus about 13% for the Vanguard Russell 2000 ETF, though performance has been roughly matched year to date through April 20. The article argues that lower valuations, a weaker U.S. dollar, AI spillover, and foreign infrastructure/defense spending support continued international small-cap outperformance.

Analysis

This is less a clean “international beat U.S.” story than a valuation-and-breadth rotation signal. The market is rewarding balance sheets and cash-flow duration outside the U.S. because foreign small caps offer a cheaper way to express the same macro beta investors have crowded into domestically—especially as U.S. leadership remains highly concentrated and vulnerable to multiple compression. The second-order effect is that international small caps tend to benefit most when global PMIs stabilize, because their earnings are more operationally levered than large-cap exporters and less dependent on one mega-cap narrative.

The currency channel is doing real work here. A softer dollar magnifies reported returns for U.S. investors and usually eases financial conditions for non-U.S. borrowers, which is constructive for local demand and capex. Add fiscal impulses in defense and infrastructure, and you get a more durable earnings tailwind than the market is pricing in for the next 2-4 quarters, especially in Europe and Japan where small-cap exposure is more domestically oriented than U.S. small caps.

The contrarian risk is that this trade becomes too consensual if U.S. growth re-accelerates or if the dollar rebounds on higher U.S. real rates. International small caps also carry hidden fragility: they are more exposed to trade frictions, funding costs, and weaker liquidity than the headline index suggests, so a risk-off shock can hit them harder than large-cap international funds. In other words, the thesis is good for months to years, but it can get punctured over days to weeks if FX reverses or global credit spreads widen.

The AI angle is underappreciated: the market still treats AI as a U.S.-only capex story, but the real trade is diffusion—automation, industrial software, and semiconductor equipment demand spreading into Asia and Europe. That broadens the opportunity set beyond mega-cap U.S. winners and increases the odds that international small caps with niche industrial exposure see earnings upgrades before they re-rate. The move is probably only half-done if investors are still benchmarking against U.S. large caps instead of looking at relative valuation plus earnings revision breadth.

Key Decisions for Investors

• Go long VSS vs short VTWO on a 3-6 month horizon: express the view that international small-cap valuation rerating and FX support will outpace U.S. small-cap cyclicality; target a 5-8% relative spread, with a stop if the dollar index reclaims recent highs.
• Add a tactical long in EFA or IEFA against a short in SPY for a balanced international-over-U.S. rotation trade; best entry on any U.S. market strength that widens the valuation gap further, with 2:1 upside/downside if the dollar weakens another 3-5%.
• Buy VSS on pullbacks below recent momentum support and hold through the next 1-2 earnings seasons; the risk/reward improves if global PMIs firm and central banks remain easing-biased outside the U.S.
• For higher conviction, pair long international industrials/cyclicals exposure with short U.S. mega-cap growth proxies (e.g., QQQ) to isolate the breadth trade; this is most attractive if U.S. rates stay sticky and earnings revisions broaden overseas.