Dave Eldreth: As we’re seeing more globalization on almost every aspect of society, the same can be said of the world’s financial markets. Welcome to Vanguard’s Investment Podcast series. I’m Dave Eldreth. This month we’re joined by Vanguard investment analyst, Yan Zilbering, one of the authors of a recently released research paper entitled Vanguard’s framework for constructing globally diversified portfolios. Welcome, Yan.

Yan Zilbering: Hi, Dave, thanks for having me.

Dave Eldreth: Yan, in the paper that you helped author, you talk about the importance of a top-down hierarchy to portfolio construction. Could you explain to our listeners what you’re referring to by that?

Yan Zilbering: Yeah, so a top-down hierarchy is our attempt to focus people on those things that are important and that are within their control. You’ve probably heard Vanguard’s research in the past talk about things that are within your control: “Stick to those, avoid the noise.”

Well top-down hierarchy is exactly that. It’s focusing on the most important thing of portfolio construction, and that is broad asset allocation and diversification. We know that picking a suitable asset allocation is the most important decision of building a portfolio, and it involves taking into account certain constraints that an investor may have—their risk tolerance—and this was all put together in order to help them meet some sort of investment objective like saving a million dollars, let’s say, for retirement in 30 years.

There is a portfolio, if you look historically, that could get you there, taking into account how much risk you’re willing to take. And finding your required rate of return to achieve that certainly helps. And the reason we start with the top-down hierarchy with the asset allocation is because we look at various studies that have been done over the many years and that continuously show that asset allocation is responsible for most of the return and variability of those returns of a diversified portfolio over time. And even our own Vanguard study that we’ve done numerous times and updated more recently, we show that over 90% of a portfolio’s return in variability could be explained by the asset allocation, by its strategic asset allocation.*

The other 10% is all the active stuff, so finding a manager, market timing, and so forth. But, unfortunately, we find that many investors focus on that other 10%. They construct their portfolio bottom-up. They’re basically fund collectors in a sense. And what that ends up leading to is a portfolio that might not necessarily meet their ultimate objective, their investment objective.

Dave Eldreth: So when you refer to fund collectors, they just piece together funds and they might not work holistically together and do what they need to do, right?

Yan Zilbering: Yeah, so it’s basically looking at a fund that may have performed well over the past calendar year and thinking, you know, I don’t want to miss out on this good-performing fund. Or it could be thinking that I need to invest in some regional fund because I believe that region’s going to do well next year. It’s trying to market time. Or it’s picking a fund on the fixed income side because you think interest rates are going to go up. So it’s all these things, or even picking managers just because they’re a highly ranked star manager —”five-star managers” we hear all the time. It’s picking based on some kind of performance.

Dave Eldreth: Okay. Now when you’re taking that top-down approach, how is different factors like time horizon, risk tolerance, how do those impact the asset allocation decisions?

Yan Zilbering: Sure. So when thinking about the asset allocation, literally those things that you just mentioned—time horizon, so your objectives; so suppose you’re saving for retirement and you have 30 years to do so, that is your time horizon. And you may have some constraints around that so you know you can save maybe $1,000 a month, or whatever it may be. Your constraint can also be the starting balance of your portfolio. So perhaps you’re already starting with $50,000. And then there’s a certain risk tolerance that you have. So are you able to withstand market volatility when your portfolio drops 20% or 30%? Perhaps if that’s something that where you’re not able to stick with a strategy like that, maybe perhaps a more conservative portfolio is more suitable.

So it’s balancing out those needs for reaching your investment goals so you can calculate your required rate of return, essentially, that would get you to your say $1 million in 30 years in retirement after adjusting for inflation, and then balancing that out with various asset allocations, picking your mix of stocks and bonds that’ll get you there.

Dave Eldreth: Okay. Now for advisors who are looking to add an international component to their clients’ portfolios, provided they don’t already have them, what’s a good starting point, and what types of investments should they be looking at?

Yan Zilbering: After determining your asset allocation, so your stock/bond mix—typically, stocks being your risky assets; bonds diversifying that stock risk—then the next step in that hierarchy that we discussed earlier is sort of looking at the underlying asset allocation, so the subasset allocation. And one of the things that investors should look at is diversifying internationally, so outside of their home country. So for a U.S. investor, it would be allocating to stocks and bonds outside of the U.S.

A good starting point for those portfolios that don’t already have allocations outside of the home country is to look at the global market cap. So, for example, an advisor can look at a FTSE global all cap index and see that the U.S. represents roughly 55% of the equity market, and perhaps the portfolio starting point is around 55% to match that market cap.

Same thing on the fixed income side. The U.S. represents about 45% of the global market cap, so a portfolio where your U.S. fixed income holdings are roughly 45% is probably a good starting point. And we think a reasonable default option to do that and to execute on something like that is to use a global market cap index fund. It’s a low-cost way of getting access, broadly diversified exposure to those asset classes, and diversified internationally.

But we know there’s certain restrictions, and some investors, maybe they have a preference for their home country because there’s a comfort level there. So we know that’s not necessarily always the best way to do it, and having some exposure there is better than none. And we do find that there is a home bias in most investors’ portfolios where they have more exposure to their home country than outside.

Dave Eldreth: When you say “home bias,” is that exclusive to U.S. investors, or do investors generally have a natural home bias?

Yan Zilbering: Oh, it’s definitely not exclusive to U.S. investors. In fact, the U.S. has probably, of all the countries we’ve looked at, has the least amount of home bias. And we have about 50% overweight, so U.S. represents about 55% of global market cap. U.S. investors hold about 79% of their equity portfolios in U.S. stocks. So that’s roughly a 50% overweight.

When we go outside of the U.S., if we look at countries like Canada, for example, that country market cap is only 3%. But if you look at the exposures to Canadian equities there, you see that investors hold about 54%. So you can see 3 to 54 is a substantial overweight to market cap, a much heavier allocation to their home country. And when we go to other regions around the world, we see similar trends.

But this is not unusual. These trends result from several factors. Some of them are unintended, so portfolios are built over time, and that’s just sort of where they land. But sometimes there are practical considerations for why an investor has a home bias. Those considerations include cost, so investing internationally is sometimes more expensive. Sometimes there’s liquidity reasons for not investing internationally. Certainly taxes are part of that cost of preferential treatment for local securities of stocks and bonds then, certainly, there’s a reason to do that.

But there’s also in certain areas where there’s regulatory limits, so you’re only allowed to invest so much outside of your home country. So we certainly see that around the world, not just in the U.S.

Dave Eldreth: Okay. So take your Canada example for a second. With that huge overweight that you’re seeing on average for Canadian investors, what’s the potential downside for that much of an overweight in their portfolio?

Yan Zilbering: So, Canada as an example, being such a small market cap, you also have to look at what that market is, how it’s constructed. So it could be particularly heavy and concentrated in certain areas—maybe commodity type and natural resource type sectors of the market. So not only is the portfolio now heavily weighted towards Canada, it’s also heavily weighted towards a specific sector of the market. And that goes across any country you go to.

[In the] U.S., we’re lucky here that we’re pretty broadly diversified, and we’re pretty close to having broad exposure to various sectors, but that’s not the case in many other countries. So that should be a particular consideration there.

Dave Eldreth: So many U.S. investors say that “I have international investments in my portfolio. I invest in U.S. companies that have exposure abroad, like automakers like Ford who do business abroad,” things like that. Does that really provide them the international exposure that they could be seeking if they invested in companies who are headquartered abroad?

Yan Zilbering: Yeah, that’s a very common reason for why individuals choose not to invest in international funds explicitly. They say, “We have multinational companies in my portfolio. That’s good enough.” But research suggests that’s not always the case. A lot of these multinational companies do have business in other countries, but the performance of those companies is very much tied to the region where they’re listed.

Dave Eldreth: So what advice can you give for advisors who are looking to help their clients overcome that natural home bias?

Yan Zilbering: A good way to help the client overcome home bias is to reframe the discussion of investing internationally—investing outside of your home country. Using specific examples, concrete examples, sometimes helps with that. I like using the example of the automobile industry, for instance. If you think about talking to a client and telling them about certain companies like Ford and BMW and Toyota and asking them, “Which company do you think is going to sell the most cars next year?” None of us know that, which cars are going to sell more.

The way to ease them into that conversation is presenting an example like that and basically saying, you know, “Since we can’t predict who’s going to do well in any given calendar year, why not own them all?” And that’s essentially what we’re doing by going outside of our country. Sort of getting exposure not just to the Fords and the BMWs and the Toyotas, but also various pharmaceutical companies, various banks around the world, being broadly diversified, having exposure there.

But, ultimately, I would say that, you know, like I said earlier, having some exposure can be better than none, so if someone’s not comfortable going fully market cap international, getting them exposed to some—maybe starting off with 20% internationally—is certainly better than having none. And, ultimately, there’s no allocation that’s optimal and certainly not for every investor. So that could actually ease the conversation.

Dave Eldreth: Okay, once all the hard work is done and an advisor works with a client to establish their financial plan and their portfolio, what goes into maintaining that financial plan and keeping it on track with what they’ve set as far as risk tolerance and their asset allocation?

Yan Zilbering: So since asset allocation is the most important decision, I would say we spend a lot of time, an advisor spends a lot of time up front, talking to their clients figuring out what their objectives are, what their constraints are, figuring out how much risk they’re willing to take. It’s crucial to stay on track. And the way we do that is we rebalance the portfolio periodically.

And why do we do that? That’s because over time we expect riskier asset classes to grow in their asset size relative to the less risky. So stocks will grow faster than bonds in a portfolio. Over prolonged periods of time, certainly in any given calendar year, that might not be the case, but if you extend the portfolio 10, 20 years, you’ll certainly expect to be compensated for the extra risk of stocks by them performing better.

Because we spend all that time up front determining what asset mix is appropriate to reach our goal, if our stock mix goes out of line with our bond mix, we need to bring that back in line and make sure we stay on track. We obviously need to reevaluate every step of the way, make sure that’s still appropriate for the goals we’re trying to meet; certainly setting up in your plan a periodic rebalance frequently. So monitor the portfolio say semiannually or annually, and if it drifts 5% to 10% beyond your comfortable asset mix of stocks/bonds, consider rebalancing those portfolios.

Dave Eldreth: Is that also a good time, when the rebalancing is taking effect, to ask the client to take their temperature on the risk tolerance? And maybe they waded into the international markets slightly and see if they’re willing to go a little further and maybe get closer to market cap?

Yan Zilbering: That’s certainly a good practice. I’m glad you brought that up. So that could be an opportunity to not just look at the stock/bond mix, but if the client at that particular moment or that particular year is more comfortable with going internationally away from their home bias, then that’s certainly a good time to adjust their subasset allocation and get them shifted closer to market cap.

Dave Eldreth: Great. Thanks for joining us today, Yan, and explaining some of these concepts to us.

Yan Zilbering: Great. Thank you very much, Dave.

Dave Eldreth: Thanks for joining us today for this Vanguard investment commentary podcast. To learn more about the issues we discussed, check out our website and take a look at our new paper, Vanguard’s framework for constructing globally diversified portfolios. And be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on LinkedIn and Twitter. Thanks for listening.

*Source: Brian Scott, James Balsamo, Kelly McShane, Christos Tasopoulos, February 2017. The global case for strategic asset allocation and an examination of home bias. Valley Forge, Pa.: The Vanguard Group.


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