Two International ETFs That Are Crushing SPY: A Historical Lens

The scale of international outperformance in 2025 was staggering. While the U.S. market grappled with volatility and concentration risks, markets abroad delivered a powerful rally. The iShares MSCI South Korea ETF, a pure play on the AI-driven semiconductor boom, surged 104% over the past year. Even more traditional markets like Japan saw robust gains, with the iShares MSCI Japan ETF up close to 31%. This stands in sharp contrast to the S&P 500 ETF (SPY) rising just 18% over the same period. The performance gap wasn't limited to these two; a broad array of international ETFs, from Europe to emerging markets, consistently beat their U.S. counterparts.

The driver was a clear shift in the investment narrative. For years, the "hands-off" U.S. thesis held sway, with the market dominated by a handful of mega-cap tech names. In 2025, that story cracked. Concerns over overvaluation and payoffs for the AI behemoths-the so-called Magnificent Seven-weighed on tech-heavy indexes. At the same time, international markets offered a more balanced structure and, often, cheaper valuations. As one analyst noted, Europe's index has its top 10 stocks making up only 17% of market cap, a stark contrast to the U.S. concentration. This diversification, coupled with policy stimuli abroad and a relatively stable global backdrop, made international assets more attractive.

Yet, the momentum itself has priced in some of this optimism. Despite their strong gains, both EWY and EWJ trade at P/E ratios around 19x. That's not a screaming bargain, but it's far below the P/E of 28.86X for the S&P 500. The setup suggests the outperformance may have marked a cyclical inflection-a rotation away from extreme concentration and toward broader, potentially undervalued global growth. The question now is whether this shift is structural or merely a tactical pause in a longer U.S. dominance. The valuations, while elevated, still imply a market that has begun to reward international diversification.

Current Momentum and Investor Flows: The 2026 Start

The momentum from 2025 is not just continuing-it's accelerating into the new year. The first full week of January delivered a striking flow pattern: international equity ETFs attracted $16.1 billion in inflows, while U.S. equity ETFs saw net outflows of $1.8 billion. This leadership shift is unusual and suggests investors are actively reallocating capital, testing the long-held "hands-off" U.S. narrative.

Performance data supports this flow trend. The Vanguard Total International Stock ETF (VXUS) is up about 4% year to date, outperforming the Vanguard S&P 500 ETF (VOO) which has gained roughly 2%. The inflows are broad-based, with major international funds like the iShares Core MSCI EAFE ETF (IEFA) and the iShares Core MSCI Emerging Markets ETF (IEMG) each gathering $1.4 billion last week. This capital is moving away from the mega-cap concentration that dominated U.S. indexes.

The setup is a classic test of market sentiment. After a year of rotation, the flow data shows the rotation is not pausing. It's a powerful signal that the diversification thesis, which drove international outperformance in 2025, is gaining fresh momentum. The question now is whether this is a sustained reallocation or a tactical move that could reverse if U.S. valuations correct. For now, the money is speaking clearly.

Valuation and Risk: The Counter-Argument

The strong performance and inflows create a compelling case, but history and current conditions also highlight the risks that could cap further gains. The most straightforward headwind is volatility. Over the past 14 years, broad international exposure through the Vanguard Total International Stock ETF (VXUS) has faced a wider potential drawdown than the S&P 500. While both indices saw their worst losses during the 2020 crash, VXUS's peak-to-trough decline was 35.97%, compared to SPY's 33.72%. This structural difference means that during periods of global stress, international portfolios are likely to experience more severe and prolonged declines, a key consideration for risk-averse investors.

Global trade uncertainty remains a persistent risk, particularly given the policy environment in the United States. While this uncertainty has fueled concerns about inflation and a slowing U.S. economy, which benefited international markets in 2025, it is a two-edged sword. As noted, the impact of U.S. policy on its own markets was more severe than on international ones last year. Yet, the potential for renewed trade tensions or protectionist measures could still disrupt supply chains and corporate earnings abroad, creating a new source of volatility that international funds are not immune to.

The case for diversifying internationally was indeed strengthened in 2025, as the evidence shows a number of non-U.S. markets outpaced the S&P 500 by a wide margin. This performance gap, coupled with cheaper valuations, justified a shift. However, that same performance has already priced in much of the optimism. The iShares MSCI South Korea ETF, for instance, trades at a P/E of 19.1x despite its 104% surge. The iShares MSCI Japan ETF carries a P/E of 18.9x. These are not deep-value levels; they are premium valuations for international stocks. The diversification thesis has been validated, but the entry point is less attractive now than it was a year ago.

The bottom line is that the rotation into international markets has been a powerful, evidence-backed move. Yet, it is not without its costs. Investors are trading the relative stability of a concentrated U.S. market for the higher potential volatility of a global portfolio, all while paying more for that diversification. The setup demands a careful weighing of these trade-offs.

Catalysts and Watchpoints for 2026

The international outperformance thesis now faces a series of specific tests. The momentum is clear, but its sustainability hinges on a few key catalysts and watchpoints that will signal whether the rotation is a durable shift or a tactical pause.

First, monitor U.S. tech earnings for signs of sustained growth. The "hands-off" U.S. rationale for 2025 was built on concerns over overvaluation and payoffs for the AI behemoths-the Magnificent Seven. If these mega-cap stocks deliver robust, profitable growth in the coming quarters, it could reinvigorate the U.S. concentration story. This would challenge the diversification thesis that has driven capital to international funds. The performance of tech-heavy U.S. ETFs like SPY and QQQ will be a direct barometer of this risk.

Second, watch for any escalation in global trade tensions. While trade uncertainty under the Trump administration has historically fueled concerns about a slowing U.S. economy, which benefited international markets, renewed protectionist measures could disrupt the very supply chains and corporate earnings that support global growth. Asian markets, in particular, are vulnerable to such shifts. An escalation would disproportionately impact export-driven economies and could quickly reverse the flow leadership seen in early 2026.

Finally, track the pace of international equity ETF inflows. The $16.1 billion in weekly inflows for international equity ETFs last week was a powerful signal. A sustained reversal of this trend-particularly if U.S. equity ETFs begin to see large, consistent inflows again-would signal a loss of momentum for the diversification trade. The flow data is the most immediate indicator of investor sentiment, and its persistence or retreat will be the clearest early warning of a thesis break.

The setup is one of validation and vulnerability. The evidence supports the move, but the watchpoints are the conditions that could quickly alter the calculus.