Other highlights from this webcast
- What’s an appropriate international allocation?
- Be aware of “home bias” in investing
- Why investing in U.S. multinational companies may not be enough
- International investing and currency hedging
Akweli Parker: Hello. I’m Akweli Parker, and welcome to our live webcast on international investing. Today, you’ll learn more about the value that international funds can add to your portfolio. And we have on hand today two experts who will provide us some basic information about international investing as well as explain how it might help us to reach our financial goals. With us today are Kim Stockton, an investment analyst with Vanguard Investment Strategy Group, and Bryan Lewis, a Certified Financial Planner™ professional with Vanguard Personal Advisor Services®. Kim, Bryan, thanks for being here, and welcome.
Kim Stockton: It’s great to be here.
Bryan Lewis: Thanks for having us.
Akweli Parker: All right. Now we’re going to spend most of our webcast answering your questions, but first, there are two quick housekeeping items that I’d like to point out. There’s a widget at the bottom of your screen for accessing technical help. That’s going to be the blue widget on your left. And if you’d like to read some of Vanguard’s thought leadership material that relates to today’s topic, or view replays of past webcasts, click the green and white Resource list widget on the far right of the player. So what do you say, Kim and Brian, ready to get this thing started?
Kim Stockton: Absolutely.
Bryan Lewis: Great.
Akweli Parker: All right, fantastic. Now before we dive into our discussion today, we’d like to ask you in our audience a question. On your screen right now, you’ll see our first poll question, which is, “What percentage of your portfolio is comprised of international investments?” And your options are 50% or greater, 30%–50%, between 10%–30%, less than 10%, or you’re not sure. So please respond now and we’ll share your answers in just a few minutes.
Now, while we’re waiting for those results to be tabulated, why don’t we go to one of our presubmitted questions, and our first question comes from James in North Potomac, Maryland. James asks, “What is an appropriate allocation to international stocks and bonds?” So Bryan, I’d have to imagine that you get some variation on this question as you’re working with clients. What do you tell folks?
Bryan Lewis: Absolutely. And I think it’s important to point out Vanguard’s approach to investing. We follow what’s called a market-cap weighting. Essentially what that means, let’s look at stocks. You take a company stock, its price or its value, and you multiply it times the outstanding shares and then it gives a value of that company. If you were to look at stocks and really do that domestically and abroad, you would find of the global stock market about half is U.S. stocks and about half is international stocks. If you look at bonds, international bonds actually represent a larger percentage of the market share than that of the U.S. bond market. In fact, international bonds are the largest asset class out there. So we certainly would want exposure there as well. So Vanguard, we typically recommend of your stock allocation that you have approximately 40% of your stocks invested in international stocks. On the bond side, we typically recommend that you have approximately 30% of your bonds invested in international bonds, and usually the follow-up question I get is, “Why?” We’ve done extensive research on this, and we will continue to do that. And I thought it would be helpful to actually look at stocks, so I actually want to bring up the diversification chart, and this is specifically focusing on the average annualized change in portfolio volatility when including international stocks with a U.S. portfolio, and it’s looking between 1970 and 2016. And there’s three different color lines here, and they represent three different asset allocations. So let’s look at the red line just for a simple example. That’s representing a 100% stock portfolio. So if you look on the far left where it shows the 0%, that’s essentially saying that you have 0% of your 100% stock portfolio invested in international stocks. So as you go left to right, you can actually see the lines begin to dip down and, essentially, what this is highlighting is as you introduce international stocks to the portfolio, it’s actually helping over the long run to bring the volatility of your portfolio down, and by volatility, the price fluctuations of the portfolio.
So as you continue to go left to right, you can actually see that the lines begin to go back up and, essentially, what that’s saying is if you begin to introduce too much international exposure, it can actually make the portfolio more volatile, which we’d also want to avoid as well. So, I thought this would be helpful.
One of the big things we’ll get into today is around the risk and how to diversify, but, over a long period of time, having international stocks within the portfolio has actually proven to bring down the volatility of your portfolio.
Akweli Parker: Got it. So you get a bit of a diversification benefit potentially as well as reducing volatility as long as you can get it to that sweet spot, right?
Bryan Lewis: Exactly.
Akweli Parker: Okay. Great. Well, our poll results are in so let’s take a moment to see how you responded to our first poll question. Once again, the question was, “What percentage of your portfolio is comprised of international investments?” So, it looks like about half of you said that 10%–30% is the range that you’re in. 30%, so about a third said less than 10%. So, any thoughts or any surprises with those numbers?
Kim Stockton: Yes. No surprises. They actually reflect a very common and understandable home bias. Home bias is just the tendency of domestic investors to overweight their local markets, their own markets. It’s very understandable. It makes sense to invest in what you know, and that’s one of the reasons we’re talking to folks today to demystify the international markets and help investors understand that the right kind of international exposure can actually lower your portfolio risk.
Akweli Parker: Great. Well, if you’ve watched our previous webcast, you know that we like to keep these interactive. So, let’s ask our audience another poll question. So this time our question is, “Which of the following is most likely to prevent you from investing in an international mutual fund?” And your options this time are, “What I read in the headlines, the geopolitical climate, I don’t see the value in international mutual funds, I don’t understand international mutual funds, or none of the above.” So go ahead and make your selection and we’ll get to your answers in just a few minutes. So, while we’re waiting, let’s take another question that was submitted in advance by our audience members, and thank you for sending those in. Our next question comes from Calvin in Omaha, Nebraska, and Calvin asks, “Should your investment be in a fund or directly into an international stock or bond?” So, it sounds like Calvin is wondering whether you should invest in an individual security versus something more broad-based like a fund. Kim, any thoughts on that?
Kim Stockton: Sure. Yes, well, you know the reason we suggest investing outside the U.S. is for diversification, to lower your risk, and mutual funds have typically been a lower-cost, simpler means to a diversification end. So if you think about cost, investing in a total international stock fund for example, that would give you exposure to 6,000-plus securities. So if you compare the cost of one mutual fund to having to go out and purchase 6,000 individual securities, it tends to be a lot more expensive to purchase individual securities relative to a mutual fund.
With respect to diversification, we think it’s important to have broad country exposure when you’re investing outside the U.S., and our research has shown probably not surprisingly to our viewers that when you look at individual equity markets in different countries, they are usually historically more volatile than the equity markets in the U.S. But when you combine your country exposures, say, in a developed market index with 20 or so countries, then if you look at historical volatility there, how much fluctuation you see in returns, it looks very similar to the U.S. markets.
Akweli Parker: Right. So that actually gets to one of the Vanguard principles for investing success, right? Have a broad, diversified portfolio.
Kim Stockton: Absolutely.
Akweli Parker: All right. Well, our second poll question results are in. So, let’s check it and see how you responded. Once again, the question was, “Which of the following is most likely to prevent you from investing in an international mutual fund?” So, looks like just under 50%, 46% of you said the geopolitical climate might prevent you from doing so. And the next highest category, “I don’t understand international mutual funds” at 15%. So, clearly the geopolitical climate is something that people are concerned about. Thoughts on that?
Bryan Lewis: Yes. And that’s not a surprise, especially with the investors that I work with ongoing is, you know, there is a lot of uncertainty out there, and investing is an emotional piece to this. And when you get into this, I think this leads into Kim’s point earlier about home biases whereas you kind of stick to what you know and you buy local, but that’s not a surprise, and, certainly, throughout our conversation today, we’ll talk more about the benefits of adding some international even with some uncertainty in the international markets.
Akweli Parker: Got it. So, we have a live question, so let’s take that. This question comes from Duncan, and Duncan asks, “Please define international. Do you consider Apple to be an international stock?” Now Apple obviously is domiciled in Cupertino, California, right here in the USA, so how do we split that difference?
Kim Stockton: Generally when we’re talking about international, we’re talking about stocks or bonds from countries other than the U.S., so non-U.S. fixed income, non-U.S. stocks.
Akweli Parker: So, does it make a difference then if you invest in a U.S. company that does have international operations? I mean, it is exposed to those international markets.
Kim Stockton: Yes, yes, that’s right, and there is the thought that when you invest in the U.S. markets, there are a number of multinational companies, companies like McDonald’s that have business and do business all over the world. So with a multinational company, you do get exposure to markets outside the U.S., but our view is that it still makes sense to have a portion of your portfolio in non-U.S. stocks and bonds for a number of reasons.
Bryan Lewis: And just to my point earlier about the market-cap weighting, right? So if you’re only investing in the United States, you’re excluding very global companies, large companies that are out there, which is roughly half of the stock market. So, it’s important that you have investments outside of the U.S. border that are domiciled outside the United States.
Akweli Parker: Good to know. Thanks for that, and thank you to Duncan for that question. Let’s go to some more of our presubmitted questions. Our next one comes from Rena in Streamwood, Illinois, and Rena asks, “How can one decide which funds? What do you look for?” And this is a two-part question. Rena also asks, “How often do we need to keep on balancing our investment?” So, two parts to that one. What do you look for, and then can you set it and forget it, or do you need to revisit and rebalance? Kim, do you want to take the first part of that?
Kim Stockton: Sure. So, one of the most important considerations when investing outside of the U.S. is that broad exposure is key. Broad exposure to sectors, broad exposure to countries, broad exposure to companies. Having that broad exposure is what lowers your risk. So, applying that concept to choosing a fund, really again a simple low-cost starting point would be something like a total international market-cap-weighted stock index fund and bond index fund. And, again, from those broad funds, you’re going to get exposure to thousands of companies, many countries with kind of a one-stop shopping. And if it’s a market-cap-weighted, it’s really much easier than trying to build broad exposure on your own.
If you build broad exposure on your own, say you invest in country index funds and build up to what is broad exposure, then you have to monitor those investments to make sure that market movement doesn’t result in over- or underweights.
Akweli Parker: Do you want to take the second one?
Bryan Lewis: Yes. An additional point as well is when you get into these international markets, you have to then decide maybe how much developed country exposure you should have or how much emerging market exposure you should have. So again, applying that whole market-cap theory behind this, generally you’ll find of the stock market about 15%–20% is in emerging markets. The rest is in developed countries. So, when I speak to investors and I’m looking at their portfolios, there’s a number of ways you can do it. It can be as simple as choosing a single investment that gives you that broad diversification. There could be hundreds, if not thousands, of stocks in one fund, or you can certainly look and buy multiple investments to give you that exposure.
I think to the second part of the question is, “Is it more of a set it and forget it or how often do you review this?” And this is what I’ll help my clients with is, you know, obviously, having a single fund can be beneficial because it does simplify how you get your international exposure, but it’s still something you have to keep an eye on given the entire portfolio. And I find a lot of investors tend to buy multiple investments and there could be overlap or— Essentially, what that means is you have a lot of the same exposure, and you just have multiple investments that are giving you the same type of exposure, but you are now complicating the portfolio in the sense that you might have too many securities, which can also present issues when you’re trying to decide maybe how to rebalance, you know, having so many different investments.
Akweli Parker: Got it. So we’ve been talking about international as kind of this very broad category. We do have another live question from Sam, and Sam asks, “Is investing in country-specific funds like Japan region or India-China region mutual funds a good idea?” So, it sounds like Sam is looking to narrow the scope of it. What are your thoughts on that?
Kim Stockton: Yes, well, again then, to me, if you are investing in individual countries or individual regions, it is a lot more work.
Akweli Parker: Why is that?
Kim Stockton: Because if you want the best diversification, the best risk reduction, you really want that broad exposure, and market-cap weighting is typically what we suggest. The market is the consensus view, so if you have something other than the market-cap weight, you are essentially betting against the market, assuming there’s a better way, and that’s generally not a bet that we suggest investors take.
Bryan Lewis: And investors who do that are taking more of a tactical approach, so I’ll talk to clients as well and they might be overweighting or underweighting in specific countries.
Akweli Parker: Can I get you to pause a second? I hear some vocabulary words being thrown in there. Overweighting and underweighting, what do we mean by that?
Bryan Lewis: Yes, so I mentioned emerging markets, right? The broad market is around 15%–20%. So, let’s say there’s an investor out there that believes emerging markets might do better, so they actually might put more of their international portfolio allocated to the emerging markets and then maybe take money away from the developed countries. And in doing that, it’s very much what I call a tactical bet. You believe that the market-cap weighting approach is probably not the right allocation that you should be doing, and a lot of investors I believe are looking for the needle in the haystack, and Vanguard’s approach is more of broad diversification. Let’s focus on buying the haystack rather than trying to go out and find that needle.
Akweli Parker: Got it. Very good. So, let’s go to another one of our presubmitted questions and this one is from Jingson. I hope I’m pronouncing that correctly. Jingson asks, “Into what kind of accounts, taxable or tax-advantaged, should we put our international investments?” So, it sounds like Jingson has a bit of an asset location question. Brian, do you hear this? What do you typically tell folks?
Bryan Lewis: Absolutely. I think this is one of the most overlooked pieces of portfolio construction. So first you have to determine what your goals are. You determine your asset allocation, which is your stock, bond, and your cash ratios. You can start focusing: All right how much international exposure should I have or how much domestic exposure I can have. You maybe say you’ve decided upon which investments that you choose.
One of the biggest pieces to portfolio construction is looking at this concept that you alluded to. It’s called asset location. Essentially what that is, is you look at buying tax-efficient investments in a nonretirement account such as a joint account or a trust account, and then you look at buying the tax-inefficient investments inside a tax-deferred account, which is an IRA, a 401(k) where it’s tax-deferred.
Akweli Parker: Got it. Now is probably a good time to remind viewers as well is that if you do have a tax question, it’s probably a good idea to consult a tax advisor or a personal advisor.
Let’s go to another live question, and just keep them on coming. We appreciate you sending those in. Our next live question is from Bruce, who asks, “When attempting to increase allocation in the international stock funds, is it better to dollar-cost average into the international funds from another fund or drop in with a lump sum?
Bryan Lewis: I can take that. So, we’ve done extensive research on this, and when I’m talking to my clients and you’re trying to get to the target allocation, Vanguard’s recommendation is you get there sooner rather than later. I think we’re the first to admit we don’t know what’s going to happen in the sense of market performance, but with all of our research that we’ve done, you know, and for viewers for dollar-cost averaging, essentially what that means is moving in more gradually versus a lump-sum investment where you get there as quick as you can. And with all of our research, about two-thirds of the time, we found that it’s better to do a lump-sum adjustment to get to the target allocation sooner than later rather than move in more gradually through a dollar-cost average approach. Obviously, you have to be mindful of taxes, but Vanguard would recommend that you get there sooner rather than later.
Akweli Parker: Got it. Okay, our next question is from Christina, and Christina asks— Well, she says that her investments in international stocks have languished this past decade, and she continues, “I’ve been afraid to invest any more into international stocks. Is that irrational?” So, we’ve seen what international stocks have done over the past decade, no great shakes, but recently we’ve seen a little bit of a difference there. So, what would you tell Christina?
Kim Stockton: Yes. Well, first off, it’s not at all irrational, and congratulations on having some international allocation and realizing the diversification benefits that they can provide. What I would suggest though is when determining your allocations outside of the U.S. to non-U.S. stocks or bonds, to not base that on historical performance.
The reason for that is twofold. First, the performance leadership between U.S. stocks and non-U.S. stocks has alternated over time. So, yes, non-U.S. stocks have had a nice run in the last 10 years. If you go back 10 years prior, the opposite was true. And, as you just mentioned, Akweli, this year it looks a little better for international stocks relative to U.S. stocks, not that I am suggesting any kind of inflection point there or suggesting that investors try to time the inflection point, which is the other part of the answer. That it is incredibly difficult to time when that performance leadership will change, even for professional money managers. There are just too many variables you have to get right. So, we don’t suggest that. Instead, we suggest a broad exposure and maintaining that broad exposure over time.
Akweli Parker: Right. Okay. Well, I’m going to ask you a follow-up from one of our viewers very much related to this. Gerald from Annandale, Virginia asks, “Is it a good time to overweight one’s portfolio with international stocks?” I mean, we have seen a difference in, like you just said you don’t want to call it an inflection point just yet but, you know, you see where things are headed. What should Gerald do?
Kim Stockton: Right. Yes. Well, in our view, anytime is a good time to have international stock and bond exposure, and this is something that we’ve done a lot of research on. Is it possible even for professional money managers to time the markets and make these kind of bets successfully? And the reality is that it is just very, very hard. Very few get it right. You’ve got too many bets you have to get right. You have to know when to get out, when to get in, how much to take out, where to take it out from. So, really, it’s a whole lot of extra risk without a lot of likelihood of success to go down the market-timing path.
Bryan Lewis: And that’s a great point, and I would say that you have to be right twice, right. You have to know when to get out and when to get back into that, and professionals do not do that well, let alone the typical investor.
When you get into trying to figure this out, international stocks have, over the last several years, have not done as well as domestic stocks. The exact opposite has happened on the fixed income side. International bonds have outperformed domestic bonds. So, that’s part of the diversification benefits, right? We want to get you from point A to point B with more of a smoother portfolio return rather than a lot of these peaks and valleys and larger swings in the portfolio performance or even the volatility that you’re going to experience.
Akweli Parker: Right. Well, we’re going to take another live question right now, and our next question is from Mary. And she’d like for us to rewind a little bit and maybe talk a little more in depth about market-weighted; what exactly that phrase means. If you could redefine that.
Bryan Lewis: So, market weighting, essentially when you look at— Again, a good example is Vanguard wants to replicate what the market weighting is, and essentially what that is, if you take the value of a stock, so the price of a stock. You multiply it times the share quantity. You get the value of this company. And if you were to do that, both domestically and abroad, you would again find about half of the global market is in U.S. stocks and about half is overseas. So when we get into our recommendations around how much international we should have, we should try to closely match that. Obviously, we want to be cognizant of a home bias as well, comfort level with clients. And that over the years has changed based on Vanguard’s research. So, for example, on the stock side, we’ve actually increased our international weightings over recent years. We started out with 30% and a couple years ago went up to 40%, and that’s based on changing market conditions and weightings with that as well. And then on the international side, I mentioned on the stocks about 80%–85% in developed countries and about 15%–20% in emerging markets, and we want to try to allocate that accordingly within our international stock exposure.
Kim Stockton: One thing to add to that is, you know, you look at the market-cap weighting and what we’re suggesting for investors right now. We are not suggesting right now a market-cap weight. The fixed income markets, the non-U.S. fixed income market is the largest capital market in the world. It’s 60% of the fixed income market. So when we make suggestions to our clients and in our single-fund solution portfolios, the allocations we have there, we consider market-cap weighting is a long-term goal. We would like to be there, but we also consider practical, sort of, we call them implementation barriers, right? What are costs? As costs come down, we want to increase our international exposure and get more diversification. And we consider home bias. How comfortable are investors with these markets?
Akweli Parker: I was going to ask that. How ironclad is that 40%? Is it strict across the board?
Kim Stockton: Yes. And it’s definitely not ironclad. It is specific to individual client risk tolerance. You know, you don’t want to go above market-cap weight but below that, there’s some wiggle room there.
Akweli Parker: Okay, great. Our next question, it’s a live question from Santiago, and Santiago wants to know about how returns are affected. So, his question is, “The 40% international stock allocation reduces volatility, but how are returns affected by that?” Any thoughts on that?
Kim Stockton: That’s a good question, and it brings up a good point. In our view, the reason to invest outside the U.S. is not to enhance your return. It is to lower your risk and improve your diversification. And so, if you look over long periods historically at the non-U.S. markets, compare those returns to the U.S. markets, over time in the equity markets and the fixed income markets, they’re pretty close and going forward, we would expect that as well. But because the two markets behave differently, they have different return patterns, combining the two is going to lower your risk, provide diversification, and, ultimately, you end up with a higher risk-adjusted return.
Akweli Parker: All right. Our next question comes from Lori from Maine, and Lori asks us to please discuss the risks and rewards of international investing. We’ve talked about some of the rewards: diversification, mitigating volatility, right? What are some of the risks?
Bryan Lewis: Absolutely. In looking at, you know, there’s country risk on the stock side, right, going into other countries. There’s currency risk. So one of the big points here, and we’ll get into with, you know, hedging on the bond side, but when you get into stocks, we want exposure outside of the U.S. dollar. So, we want other currency exposure. So, there could be some risk there as well from a currency perspective. On the bond side, there’s interest rate risk, and that really applies to bonds generally speaking as well. I think, Kim, you mentioned this already, is barriers to entry when you think of cost. Typically, when you get into investing internationally, the cost is typically a greater expense when you think of the expense ratio, which is just the cost to manage a mutual fund or an ETF. The costs are higher relative to that of a U.S. counterpart, so that’s something to be mindful of.
And with a lot of our research, we are looking historically speaking so nobody knows obviously what the future holds, but there are, you know, we talked about reducing volatility as a key driver of why you want to diversify, but there are periods of time when having international stocks or international bonds has actually increased volatility in the very short run. So, that’s something to be mindful of as well, but over time, it’s actually proved to reduce the risk of that portfolio.
On the stock side, I also want to point out as well from a diversification standpoint, we haven’t really got into this yet, is the sector weightings of what’s in the United States when you think of, for example, healthcare, IT. The U.S. market’s higher allocated to that than that of the international markets. These old-world industries overseas tend to have consumer goods as a focus, automobiles. You get additional diversification by going outside. But I think we’ve alluded to this as well. One of the biggest risks of not investing overseas is this idea of home bias, and home bias is where you really stick to what you know; you buy local. And the idea is these U.S. companies and stocks and bonds, people believe they can invest in these domestic markets and really never have to go outside of the border. What we found with the performance, as we were alluding to this earlier around the source of revenue, is the performance of the stock itself more closely follows or correlates the market or the domestic market in which they trade in rather than their source of revenues. So if a company has 40% of the revenues coming from overseas investments, that stock in a poor market based on perception is probably not going to trade or do as well even though a lot of the revenues might be diversified.
And the U.S. isn’t alone. A lot of developed countries have this home bias, but when you get into the fear, when I talk to clients of getting into international markets, it’s the fear of the unknown, as I say, just the political uncertainty, the concern around economic outlooks, the monetary policy. So what investors inadvertently do is find themselves taking more risks just because they are not allocated across the globe as much as we would want.
Akweli Parker: Right. So, it’s actually a risk to harbor this home bias and miss out on that opportunity set of the global markets, right?
Bryan Lewis: Correct.
Akweli Parker: All right. Our next question is from Joanna in San Diego, California, and Joanna asks, “How correlated are U.S. and foreign markets?” So, Kim, I know some of your research has touched on this. In answering Joanna’s question, maybe you could define what we mean by correlated/correlation.
Kim Stockton: Yes, well, I suspect the question is arising from the fact that correlations have risen, correlations between the U.S. and the non-U.S. markets over time. And what we mean by correlation is just how one market or asset class moves relative to another. So, if you have a perfect correlation, that means two markets move exactly in lockstep, a correlation of 1. If you have correlations less than that, that means they don’t. So in that case, maybe you have, say, the non-U.S. stock markets one year they’re down, the return is down, but the U.S. stock markets aren’t perfectly correlated with the non-U.S. stock markets. So maybe that year they may be down but not by as much. So those two returns, the better return can offset the worse return, and over time, that gives investors a smoother ride. That’s correlation and that’s diversification. And that’s really how international investments, when you add them to a non-U.S. portfolio, lower risk over time.
Akweli Parker: It’s a bit of a complicated topic, but thanks for explaining it, and thank you, Joanna, for asking that question. We’ve got another live question. This one is from Luis, and Luis asks us to please define risk-adjusted return. What do we mean by that?
Kim Stockton: Yes, sorry. So that’s if you think of your return in isolation, you know, maybe you get 9% in the U.S. one year and 8% in the non-U.S. markets one year. Over time, those returns have a lot of volatility, and that has an impact. So, one measure of success that we apply to portfolios is, let’s take a look at the returns, but let’s see what return we get for a given level of volatility. Investors, they may like the idea of a 25% return, but if to get to that 25% return from year to year, your portfolio is going up and down dramatically, that’s something that investors maybe aren’t comfortable with. So, it’s an important consideration—not only just returns but within consideration of risk.
Akweli Parker: Great, thank you, and thank you, Luis, for sending in your question. Our next question comes from Catherine in Miami, Florida, and Catherine asks, “Are international ETFs a good option?” So, Bryan, do you want to take that one?
Bryan Lewis: So, ETFs are exchange-traded funds, and they’re basically mutual funds that trade like a stock throughout the day. So, you can buy it, you can sell it throughout the day. So, ETFs can be a reasonable option. Back to our points earlier, you need to have broad diversification. So, you could theoretically buy a single ETF that’s giving you the developed market exposure, some emerging market exposure. You do have to be aware when you’re looking at ETFs, certainly cost is important. One thing a lot of investors overlook is what’s called a bid/ask spread, and essentially what that is, it’s the price that someone’s selling it at and what you’re buying it at. There’s a difference there, and it’s called a bid/ask spread. For international investments, it tends to be greater than that of, say, a U.S. ETF. So, it’s something to be mindful of, but when you get into the ETFs, they are very reasonable. They could be held in a tax-sheltered account or a nonretirement account typically because they are tax-efficient as well. It’s something you could definitely include into the portfolio if you have a preference for ETFs.
Akweli Parker: Okay, it just depends on if you’re looking for those advantages of ETFs.
Bryan Lewis: Correct.
Akweli Parker: Okay. Our next question comes from Fred in Tulsa, Oklahoma, and Fred asks, “Due to the complexities of international investing, are actively managed funds” (I believe he means actively managed international funds) “better than index international funds?” So, we get to the old active versus passive, active versus index debate. Kim, do you want to take a shot at this?
Kim Stockton: Sure.
Akweli Parker: Is there a difference if we’re talking internationally versus domestic?
Kim Stockton: Yes. That is a question we get a lot. Are there certain markets where active will do better? With respect to international markets, this is something we’ve looked at and done a lot of research on. And for the past 10 years, for example, if you look at the performance of active relative to the index, 80% have underperformed the index after cost.
Akweli Parker: Wow.
Kim Stockton: And to take that one step further, it’s sort of a common misperception that in markets that are inefficient, so markets where information isn’t flowing as freely like the emerging markets, and those markets are seen as having more opportunities. So, the thinking is active management should do better there. So, we looked at active managers, we went back and looked at 2007 through 2011. We looked at the top 20% of managers in that period, and then we followed them 5 years later. We wanted to see how persistent do these same active managers who outperform in 1 period keep outperforming over time. And when we looked at those same 20% in the next 5 years, guess what happens? Most of them are in the bottom 20%. Only 6% stay in the top 20%. So, not that we’re averse to active management, we have a number of active funds. It’s just important if investors would like to engage in active management, they understand the risks, the low probability of success, and absolutely critical is that they find the low-cost active managers because we know there’s skill out there. We know there are active managers that can add value, but we live in a free market. They charge for that skill, so you need to be sure that if they are earning an excess return, they’re not charging that away. Otherwise, it’s uncompensated risk. You’d be better off in an index fund.
Akweli Parker: Right. Like Bill McNabb says, it’s not necessarily active versus passive but high cost versus low cost.
Kim Stockton: Absolutely.
Akweli Parker: And indexing just happens to be lower-cost most of the time.
Kim Stockton: That’s right.
Bryan Lewis: I will add just from a portfolio construction standpoint, there is absolutely nothing wrong with having actively managed investments in the portfolio, but just be mindful, to my point earlier, around the asset location concept.
Akweli Parker: Great point. We have another live question, and this one is from Dan. And Dan asks us, “What is an easy way to invest in foreign markets with a balance between stocks and bonds?” So, how can you do it easily?
Kim Stockton: Yes. Well, again, I think a broad market-cap-weighted total international stock fund or a bond fund is a really easy low-cost way to get exposure. It’s market-cap-weighted so you don’t have to worry about over- or underweights emerging over time, and it’s low-cost.
Akweli Parker: All right, thank you, and thank you, Dan, for that question. There’s a question that I want to circle back around to. You touched on it briefly, Bryan. This one is from Nagaraj in Voorhees, New Jersey, who asks us to “Please explain currency hedging.” So, what is currency hedging? Why is it something that someone might want to consider doing?
Kim Stockton: Sure. So, currency hedging is done with a forward contract. It’s when two parties agree to exchange one currency for another at a set rate in the future. And the whole currency hedging process is very complex, very technical, but the benefit to currency hedging is very straightforward. And that is when you hedge your currency, you are locking in the exchange rates today, which means that you are removing from your portfolio the volatility that would come from currency changes, relative currency changes in the future. So the dollar changes relative to the yen, it’s a lot of volatility that can be added to your investment if you don’t hedge it.
Now, we generally suggest hedging on the non-U.S. fixed income side and not so on the non-U.S. equity side. The reason for that is I mentioned currency is volatile. Even a broad exposure to currency is volatile. It looks similar to volatility like you’d see in an equity market. So when you have currency volatility and equity volatility together in one portfolio, there is not a whole lot of difference in your average portfolio volatility. It doesn’t change anything to have that currency volatility in there.
The fixed income markets are much more stable. So, a non-U.S. fixed income broad market exposure is pretty stable. If you add currency volatility to that kind of investment, you basically end up with an investment in currency. It really overwhelms your fixed income investment. So, in the non-U.S. fixed income markets, we suggest that you hedge that away.
Akweli Parker: Got it.
Bryan Lewis: And that’s to the point too. If you take a step back when you talk to a client about the asset allocation, right? So, we want you to take the risk on the stock side, not with the bonds, right? We want to mitigate as much risk with the bonds. They’re really there to provide stability as well as for investors that need income. Obviously, yields are low, but they still serve a purpose in really being more of a safety net. So, we don’t want to take any unnecessary risks there unless we absolutely have to. Let’s focus on doing that on the stock side.
Akweli Parker: Right. Speaking of mitigating risks, I want to take this question from Scott in Cedar Rapids, Iowa. Scott asks, “Does Vanguard believe that the percentage of international equities and bonds of your total portfolio should decrease as a person nears retirement?” So, we talk about reducing one’s exposure to equities as one nears retirement. Does something similar apply to international securities or no?
Bryan Lewis: So, regardless of your age, Vanguard usually recommends you stick to these targets, and that could be, say, somebody who’s right out of college when you’re an accumulator trying to focus on growing the portfolio; you might have, say, a 100% stock portfolio. And as you get closer to retirement, the idea, and this is what I’ll help my clients with, is you dial back the stock risk, take your foot off the accelerator and start putting more of maybe the bonds into the portfolio as you get close to retirement or even into retirement. As a percentage, though, of the stock or bond allocation, they can change. So, for example, if you have a young investor that’s 100% in stocks and you target 40% of the stocks in international, you have 40% total in international stocks. As you, say, get close to retirement, and now you’re targeting half stocks and half bonds, of the stock allocation you have 40%, which actually now represents about 20% of your entire portfolio is now invested in international stock.
So it does go down over time on the stock side, but on the bond side it actually starts to go up using those same percentages, right? So as you add more bonds and if you’re targeting 30% of your bonds with international bonds, the more bonds you have, the more international exposure you have. But the percentages themselves, they really shouldn’t change as you progress from these different stages of your investing career. In fact, Vanguard has actually increased our international targets based on our research that we’ve done, and that applies for young investors and older investors as well.
Akweli Parker: When we talk about these targets: How flexible are they, and what are the parameters that they would depend upon?
Bryan Lewis: It very much depends on an investor’s risk tolerance. I’ll work with clients, and I’ll propose Vanguard’s recommendations. But if an investor’s not comfortable with that, as an advisor, I want to work and make sure we’re meeting their objectives and their comfort level and certainly their risk tolerance. So, it’s a starting point, and if an investor is not comfortable with it, there’s certainly a very reasonable range. Really, hopefully the takeaway is any level of international investments in the portfolio has proven to be a way to reduce risks and improve your diversification. So, as long as you have a very reasonable amount, it’s very suitable.
Akweli Parker: Got it. I want to circle back to talking about currency. Tse, T-S-E—I hope I’m pronouncing that correctly—asks, “How concerned should an investor be when it comes to currency devaluations or currency wars between other nations?” Kim, can you talk to that? What do we mean exactly by currency devaluation? How does that work?
Kim Stockton: Sure. So the question is in regards to how one currency is valued relative to another, and sometimes countries manipulate that value. That’s currency devaluation. Sometimes the markets change that relative value, so maybe the dollar goes up relative to the yen. And how that impacts portfolios, it’s different depending on whether we’re talking about the non-U.S. markets, stock markets, or the non-U.S. bond markets.
So for stocks since we don’t suggest hedging there, you would see the currency volatility, but we also suggest, as I’ve said, a broad exposure. So if you’ve got a broad international exposure, your currency exposure is also broad, so chances are one country is devaluing, another one is doing the opposite. So just like other factors, they are offsetting.
Now on the fixed income side, as I mentioned, we suggest a hedge position, so there the currency risk is removed from the portfolio. So any devaluations or changes in currency values relatively do not impact those portfolios.
Akweli Parker: All right. Let me take this next question from Matthew, and Matthew asks, “In the U.S., the S&P 500 is used as a measuring stick of portfolio performance here in the United States. Is there a global stock market benchmark that combines all countries’ equity markets?” So, what’s our yardstick when thinking internationally?
Kim Stockton: Yes. So the S&P 500 is used that way; the questioner is correct. But, in fact, the S&P 500 is actually just the largest companies in the U.S., so it’s a good, you know, idea. It gives you a good idea of what the market’s doing generally, but it’s really not a good benchmark of a U.S. equity portfolio if it’s broadly exposed because the largest stocks represent about 70% of the U.S. market; there’s the other 30% that you need to consider. But there are global benchmarks, like the FTSE Global All Cap Index is one, that includes the U.S. markets, the developed non-U.S. markets and the emerging non-U.S. equity markets.
Akweli Parker: All right. We have a question that wants us to talk through one of the charts, the diversification of stocks chart. Can one of you lead us through that? Walk us through.
Bryan Lewis: Yes. I’m going to pull this up. So, specifically, this chart, when you get into the international, this is only looking at the stocks, and the idea again is the starting point there on the left is that you have 0% of the portfolio invested in international stocks. As you go left to right, this is again measuring the volatility or the price fluctuations of the stock allocation. So, over a long period of time in these examples of different allocations and really all allocations, it’s really helped to reduce those price fluctuations within the portfolio.
So, this gets into Akweli, your question around, you know is it you have to have 40% of your stock allocation invested in international stocks? Well, no, not necessarily. That’s just where we believe you should be but, again, when you get back to— This chart does a nice job of really illustrating that any level of international stock exposure really helps to give you the diversification, and it also is helping over a long period of time to reduce that volatility. That’s probably one of the few times you want to see some negative numbers here, right? You want to be able to bring that price fluctuation down in a portfolio.
Akweli Parker: Absolutely.
Bryan Lewis: And as an advisor, my objective for my clients is to get them from point A to point B with the least amount of risk, and this is a great way to do it.
Akweli Parker: Right. I don’t know about the two of you, but I found this to be a fantastic, enlightening discussion. So, I just want to thank the both of you. I wish we could go on but, unfortunately, we’re out of time. So, before we sign off, any parting thoughts, Kim? What are your takeaways from this conversation?
Kim Stockton: Yes. One thing I’d mention is we talked a little bit about the non-U.S. fixed income markets. I don’t think we talked a whole lot about them, and they are very underrepresented in investors’ portfolios, and they have been historically, not only diversifiers of U.S. equity, but also of U.S. fixed income. So, don’t forget about the non-U.S. fixed income markets. Valuable diversification there too.
Akweli Parker: Great points. Bryan?
Bryan Lewis: And I would also add that international investing in stocks and bonds, again, proves to reduce the risk, but again, be very mindful of where you’re buying those investments. You want to be mindful of owning the tax-efficient investments which, again, are those stocks or stock index funds in those nonretirement accounts, and the tax-inefficient investments in the tax-deferred accounts, such as the international bonds, would be better suited in tax-deferred accounts. So just be mindful of that, but again, the multinationals, really the U.S. companies don’t always give you the diversification that you need and, certainly, give Vanguard a call. We’re happy to talk more about that.
Akweli Parker: That’s a fantastic point to close on. Thanks again to the both of you, and thank you for tuning in and participating and for sending in all your great questions. They really contributed to this fantastic discussion we’ve had.
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Narrator: For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus. Read and consider it carefully before investing.
All investing is subject to risk, including the loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.