Going overseas without going overboard
The idea of holding a portion of your portfolio in non-U.S. stocks has been around for quite some time, but the ways in and reasons for which it’s put into practice have evolved.
At first, the addition of non-U.S. stocks provided another level of diversification, as these markets did not move in perfect tandem with the U.S. market. Today, it’s harder to discern the difference between markets in the United States and abroad—just consider the events of the past year.
Also, there weren’t initially that many options for individual investors looking to gain access to these investments. Today, there are over 730 funds* that specialize in international stocks (2,600 if you include all of their share classes!).
While many people agree that international investing is a generally solid concept, there remain three fundamental questions each investor needs to answer: (1) Is an international allocation still important? (2) How should I get that exposure? and (3) What’s the right allocation?
The answer to the first question is yes, in my opinion. The initial thinking around holding non-U.S.-based stocks was that they could provide additional diversification and return. Today, the emphasis is more on the diversification benefits. There’s also the opportunistic aspect: Why limit your portfolio only to U.S. companies when there are so many attractive companies outside our borders?
There’s been quite a bit of debate around how to gain international exposure: a direct investment in an international fund, or indirectly, by owning companies that derive a large portion of their earnings outside the United States? While it’s true that many U.S. companies today are global in nature, and their earnings can benefit from economic growth in other countries, the stock performance of these companies will still be most highly correlated with overall U.S. stock performance. Approaching international investing this way may not give you the diversification benefits.
The “how much” decision is complicated by the number of ways to calculate the appropriate international exposure. One way is to hold investments by country according to the percentage of total world GDP each represents. Under this methodology, a U.S. investor’s portfolio would have 25% in the United States and the balance in other countries.** Another way is to divide your portfolio using each country’s market value as a percentage of the total. By this measure, the United States would represent 42% of an investor’s portfolio, and non-U.S. holdings 58%.**
Unless one has the time and resources to keep track of these statistics, it might be better just to hold a flat percentage in non-U.S. stocks. In order to get any meaningful exposure, consider starting with at least 20% of your equity portfolio invested in non-U.S. companies. A higher allocation could be appropriate for investors who wanted more exposure.
There are three other factors to consider. First, many funds that invest in U.S.-based companies may also invest a certain percentage of assets in non-U.S.-based companies. Be sure to factor this into the equation when calculating your portfolio’s overall exposure. Plus, remember that many U.S.-based companies can earn a significant portion of their earnings from business outside the United States. Finally, consider taking a page from the corporate world and making sure that the bulk of your assets are denominated in the same currency as your liabilities (i.e., your spending needs). For most U.S. investors, that currency is the U.S. dollar.
* Source: Morningstar, as of September 30, 2009.
** Source: MSCI, as of September 30, 2009.
Note: All investments are subject to risk. International investments are subject to additional risks, including currency fluctuation and political instability. Diversification does not ensure a profit or protect against a loss in a declining market.
The advice to invest assets in the same currency as one’s liabilities certainly seems sound, the reason being risk of currency fluctuation, I assume. However, as a senior citizen with no liabilities (debt), I would like to have investments denominated in other currencies just to get some assets out of the American dollar which I feel will continue to lose value as more and more are both printed and borrowed in unprecedented quantities - not to mention the commitments to Social Security and Medicare which are way beyond the nation’s ability to meet.
How about addressing the safety of the assets of our seniors - most of whom I think would have little or no debt.
Very nice article. Short and to-the-point. Interesting comparison of GDP and Market Cap allocation. Thought provoking comment about keeping assets and liabilities in the same currency. Thanks.
I guess I’ve just never understood why it was prudent to allocate nearly every other asset class according to a market weight with the EXCEPTION of the global equity markets. One makes the assumption that they know more than the market does when their portfolio deviates from this simple rule. I understand the whole argument about the political and currency risk but does one really believe it will make that much of a difference in risk-adjusted returns by deciding to allocate 20-30% internationally vs 50-60%? I would argue that it could even be riskier to have 80% of one’s equity allocation in only one country’s market, given at least the possibility of another Japan-like scenario in ANY global equity market.
I suspect the average recommended international equity allocation will continue to creep higher in the coming years, ESPECIALLY if they continue to outperform the domestic equity markets. Over the very long-term, the currency risk should be eliminated leaving only political risk. And given what we have just seen in the US in the last 18-months, does the average investor really believe there isn’t political risk here as well?
With the speed of information and capital flows today, why would most individual investors think they are smart enough to bet against the market cap weightings of the MSCI All Country World Index?
This is much too generalized to be of any value. How about a breakdown of Emerging, Europe,Asia,Latin America,Canada,BRIC etc. And which of your funds cover each
If you live, work and will retire in the U.S. then 20% to 25% foreign exposure is adequate. The reason is you will spend in U.S. dollars. You want the diversification benefits for your retirement income. Today, more than ever, U.S. companies have international exposure. I’ve read somewhere between 25% to 40% of the S&P 500 companies derive their revenues form overseas. So that is the reasoning. Investing is very simple, but you can make it very complicated.
Vanguard’s a great company, I’ve been with them 20 years; wish they had a fund with more China exposure. Alot more China exposure.
It sounds like you’re creating problems yourself by trying to solve this issue instead of looking at why their is a problem in the first place.
Do not assume that Vanguard shareholders and blog-readers all live in the U.S.
Many don’t, and thus the world’s assets cannot be seen through the prism of US or non-US.
Vanguard has shareholders all over the world.
Remember! It is COMMUNIST China.I won’t invest my money there no matter how much return I can make. There should be a warning label on any fund investing in Communist China. It is bad enough we buy so many of their products.
I’ve just broke it down to 50% in US based equities, and 50% overseas, and then use indexes and ETF to obtain this ratio. I’m using a 60%/40% mix on equities/fixed income.
I agree that this was a well-written article and one that addresses an increasingly important issue.
However, I’m not sure I fully agree with the alternative that suggested investors take a page from the corporate world and make sure that the bulk of their assets are denominated in the same currency as their liabilities - the U.S. dollar. It seems to me that, excluding services, housing costs and food, almost everything we buy is made overseas. Wouldn’t international currency exposure be prudent to cover that portion of our expenditures?
I agree with the commentators above that one of the benefits to investing in funds that are not denominated in US currency is to offset currency fluctuation. I’d like to see more discussion of that, as well as more practically, how to tell what the fund is denominated in.
The last sentence is terrible advice
I agree with the last Dec. 11 comment and the Dec. 18 about hesitation in investing in communist China. Why doesn’t Emerging Markets invest more in India which soon will be more populous than China? How can I get more exposure to India with Vanguard?
I agree with the Dec. 11th and the Jan. 7th comments. I’ve looked over the lists of top holdings in the international funds. I would appreciate information being included on this site that breaks down the foreign companies included in a specific fund by the actual nation.
Which international fund includes the most “quality” companies from India?
Bernstein in his book The Investor’s Manifesto to avoid China because because their growth of 9.61% real over the last two decades has NOMINAL ANNUALIZED RETURN OF MINUS 3.1%.
Bills book is an excelent one for the new index investor. only 200 pages and easy reading.
The move to ETFs is fine for investments that have somewhat predictable volatility pressures and business cycles to deal with, but when it comes to emerging markets it seems that having a solid management team is essential. Otherwise, the investment bucket will constantly be swinging through unpredictable upheaval since no one filtered the company management before putting together the list of companies which would be included. Maybe Vanguard will set up a China/Taiwan/Korea/India fund overseen by consultants who know that region well enough to eliminate the less well managed companies from a portfolio? Even if China is Communist, they have to trade with the rest of the world if they want their GDP to grow.
This is a thought provoking article (thank you). I can understand international allocation based on GDP and based on market cap. Vanguard Flagship’s recommendation of holding less than 25% exposure to international equities is something I have never been able to understand even though I have read their explanation. Are Vanguard’s international funds (VEU, VGTSX, etc.) held in U.S. dollars or in the currencies of the countries in which they are invested? In other words, if the dollar became devalued in the absence of devaluation of international equities, would VEU and VGTSX values drop?
I suggest readers who are focusing on the “Communist” aspect of the Chinese economy as a reason to steer clear or minimize their exposure to China should dig deeper. The Chinese economy is a Capitalist economy under a Communist government. Most Chinese entrepreneurs find fewer government imposed obstacles or costs to starting their businesses than do their American counterparts. One result is that in the coming decades the economic growth that comes from an economy based on manufacturing (think USA from 1890 through 1950) will drive the Chinese economy substantially ahead of a US economy that is based on credit-backed consumption. Investors who avoid Chinese investments as a form of political protest against a Communist government will do so at the price of substantially underperforming their peers.