Foreign Exposure: How Much is Enough?
In a recent Wall Street Journal column titled “Placing Your Investing Chips in the Right Countries,” writer Jason Zweig addresses the oft-debated topic of the appropriate foreign allocation within a stock portfolio. Zweig concludes that, for most investors, their stock allocation should mirror the allocation of the world’s equity markets* – which is to say 42% in the U.S. and 58% in foreign markets. While we find ourselves in agreement with Zweig on many issues, on this one we must respectfully disagree.
This is a complex topic on which opinions are quite divided. Adopting a stance in stark contrast to Zweig’s is John Bogle, founder and former Chairman of Vanguard. Bogle has long maintained that no foreign stock allocation is necessary given that nearly half of the revenues of large domestic companies are already generated outside of the U.S. And, he contends, if a foreign stock allocation is included, it should represent no more than 20% of the portfolio. Meanwhile, in a departure from its founder, Vanguard’s research suggests that a 20% foreign stock allocation represents a reasonable starting point.
As with any investment decision, the rationale for an allocation to foreign equities should be rooted in economic logic and sound portfolio theory. In this case, history has shown that foreign stock exposure in a portfolio can enhance diversification and even increase expected return. However, in determining an appropriate allocation, the potential future benefit must be weighed against the additional risk and cost that may be associated with foreign investing. Below are a few of the key considerations:
- Higher costs: Transaction and investment costs are generally higher in foreign markets than in the U.S. This is primarily a result of liquidity differences and relatively lower market participation. For example, bid-ask spreads tend to be wider, and management fees and frictional costs (such as trading commissions, market-impact costs and tax costs) tend to be higher for foreign investments.
- Currency risk: Over time, currency movements contribute to the diversification benefit of foreign holdings. However, unless you live abroad, you will be spending mainly U.S. Dollars in retirement. As a result, it may be imprudent to rely on a long-term stock portfolio in which the U.S. Dollar occupies a minority position.
- Other risks: In addition to unpredictable currency fluctuations, additional risks of foreign investing may include liquidity risks and the potential for political unrest or changes in government policy that can weaken a country’s or region’s securities markets.
- Varying correlations: If the foreign exposure consists only of large-cap stocks in developed markets, the benefits may be minimal. Since its introduction in 1970, Morgan Stanley’s Europe, Australasia, Far East (EAFE) Index has returned 10.0% while the S&P 500 Index has returned 9.8%. And over the past decade, the correlation of returns between the two indexes has been very high at 0.88. Factor in the higher costs of investment and the EAFE Index can resemble an expensive S&P 500 fund. However, greater diversification benefit can be found in foreign value and small cap stocks as the companies in these categories generally conduct much more of their commerce locally than globally.
Weighing these practical concerns against the diversification opportunity suggests that some level of a “home bias” (i.e., allocating more to domestic stocks than their world market weighting would suggest) is warranted. In fact, Vanguard’s research indicates that exceeding a 40% foreign allocation has not historically added significant additional diversification benefit, particularly in light of the additional costs.
We concur with Vanguard’s findings and advocate a foreign allocation of 30-40% of the stock portfolio. Additionally, both our foreign developed and emerging market holdings are tilted to value and small cap stocks to enhance the expected return and diversification benefit. Our recommendation will evolve as the world equity markets do, but the objective will remain to adopt an allocation that substantially and efficiently captures the benefit of foreign equity exposure while remaining sensitive to the associated risks and costs.
*Postscript: A discussion with Jason Zweig subsequent to this posting clarified his position and finds us much more in alignment: he believes that the world equity allocation should serve as the baseline from which investors increase or decrease their domestic allocation based on personal circumstances.