The Hidden Risk in U.S. Equity Markets: Why Foreign Investors May Pull Back in 2026
While American investors celebrated strong portfolio returns in 2025—16.4% from the S&P 500 plus exceptional international gains—few recognized a troubling undercurrent: foreign investors experienced vastly different results from U.S. equities. The dollar’s 9.4% decline transformed what domestic investors saw as a solid year into a disappointment for international allocators. This reversal from 2024’s dynamics could signal a significant shift in global capital flows.
Key Observations:
1. A Tale of Two Markets: The Great Perception Divide
U.S. investors saw 2025 as a banner year. The S&P 500’s 16.4% return satisfied domestic allocators, while international exposure delivered windfalls—South Korea up 85%, Japan up 36%, Germany up 32% in dollar terms. But this narrative completely misses what foreign investors experienced.
A Japanese asset manager who allocated to U.S. equities earned just 5.8% in yen—less than a quarter of the Nikkei’s 26% return. A German pension fund saw only 6.0% in euros, compared with the DAX’s 23%. For UK investors, U.S. stocks returned 7.0% while the FTSE delivered 21.5%. These aren’t rounding errors—these are massive performance gaps that will influence 2026 allocation decisions.
2. The Complete Reversal from 2024
In 2024, the dollar strengthened, penalizing U.S. investors in foreign markets but rewarding international investors in American stocks. Foreign allocators earned 27-33% on S&P 500 investments (in their local currencies) while their domestic markets underperformed. That dynamic created a powerful incentive to overweight U.S. equities.
2025 flipped the script entirely. The same foreign investors who were rewarded for U.S. exposure in 2024 saw those gains evaporate. A two-year perspective makes this even starker: many foreign investors are now questioning whether U.S. equity exposure is worth the volatility and currency risk when their domestic markets are delivering superior risk-adjusted returns.
3. South Korea: The Starkest Example
The KOSPI’s 76% local return became 85% for U.S. investors thanks to won appreciation. But reverse the lens: a Korean investor who allocated to the S&P 500 earned 6.4% while their domestic market soared 76%. That’s a 70-percentage-point opportunity cost.
For institutional allocators facing scrutiny from boards and beneficiaries, explaining a 6% return on a U.S. allocation when the home market was up 76% will be exceptionally difficult. This type of performance divergence doesn’t just influence 2026 decisions—it shapes multi-year strategic asset allocation frameworks.
4. Even “Defensive” UK and German Allocators Were Penalized
It wasn’t just emerging markets. Conservative European investors who traditionally maintain substantial U.S. allocations for diversification saw disappointing results. German investors earned 6.0% from U.S. stocks versus 23% domestically—a 17-percentage-point penalty for diversifying. UK allocators faced a 14.5-point gap.
These aren’t retail investors easily swayed by one year’s performance. These are sophisticated institutions with long time horizons. But when the opportunity cost becomes this severe—and when domestic markets are delivering strong absolute returns, not just relative outperformance—even patient capital begins to shift.
5. The Dollar Effect Dominated Fundamentals
The S&P 500’s 16.4% return was solid by any absolute measure. But the 9.4% dollar decline meant foreign investors experienced returns in the 6-9% range—barely above typical bond yields and well below equity risk premiums. This wasn’t about U.S. corporate fundamentals deteriorating; it was pure currency effect. But the result is the same: foreign capital earned inadequate compensation for equity risk in U.S. markets.
6. India: The Exception That Proves the Rule
India’s BSE Sensex posted the weakest local return in our cohort at just 9.1%. Yet Indian investors who allocated to U.S. stocks earned 9.3%—essentially the same. This parity occurred because the rupee depreciated modestly against the dollar. For Indian allocators, U.S. equities served their traditional role as geographic diversification without massive opportunity cost.
This exception highlights why currency-neutral or currency-hedged strategies are gaining traction among international institutional investors. When unhedged, U.S. equity returns became a currency bet as much as an equity allocation.
7. The Capital Flow Implications for 2026
Foreign ownership of U.S. equities stands at approximately $13 trillion, representing a major pillar of support for American markets. Much of this capital came during the decade of U.S. outperformance (2010-2024), when both strong market returns and dollar appreciation rewarded international allocators.
2025’s reversal raises critical questions:
- Will Japanese institutions continue allocating heavily to U.S. markets after earning 5.8% while domestic stocks returned 26%?
- Can European pension funds justify U.S. overweights when they’re delivering 6-7% versus 21-23% at home?
- Will sovereign wealth funds in Asia reduce dollar exposure after currency losses eroded equity gains?
Even a modest 5-10% reduction in foreign allocation to U.S. equities could remove $650 billion to $1.3 trillion in support—a meaningful headwind for valuations in 2026.
The Takeaway for Investors:
In 2025, a dangerous divergence in investor experience emerged. U.S. investors saw strong absolute returns and phenomenal international gains, potentially creating complacency about risks. But foreign investors—who have been a critical source of capital for U.S. markets—experienced significant underperformance in their U.S. allocations.
Critical implications:
- U.S. markets may face reduced foreign inflows: After disappointing 2025 returns in local currencies, international allocators have strong incentive to reduce U.S. exposure
- The 2024 reversal was complete: Foreign investors went from being rewarded for U.S. allocations in 2024 to being severely penalized in 2025—a whipsaw that reduces confidence
- Valuation support may weaken: With U.S. stocks trading at 30-40% premiums to international markets, reduced foreign demand could pressure multiples
- Currency hedging gains urgency: For foreign investors, 2025 proved that unhedged U.S. equity exposure is as much a currency position as an equity allocation
- Home bias may intensify globally: When domestic markets deliver 20-70%+ returns, the case for foreign diversification weakens—especially when that diversification underperforms by double digits
Looking Ahead:
While one year doesn’t make a trend, 2025’s experience may mark an inflection point. After 15 years of U.S. market dominance and dollar strength attracting global capital, the combination of strong international equity performance and dollar weakness created powerful incentives for foreign investors to reduce U.S. exposure.
U.S. investors celebrating 2025’s portfolio returns should recognize that their counterparts abroad had a vastly different experience. Those foreign investors control trillions in capital, and their allocation decisions in 2026 could significantly impact U.S. equity valuations—particularly in a market already trading at elevated multiples.
The question isn’t whether foreign investors will completely abandon U.S. markets, but whether a marginal reduction in allocations—driven by disappointing 2025 returns and attractive domestic alternatives—could remove a key support pillar just as valuations face other headwinds.
Currency effects cut both ways. In 2025, they masked U.S. market risks for American investors while creating them for everyone else.
