So far this year, international stock returns have trailed returns for the U.S. stock market. Unless we have a drastic reversal in the last few months of the year, U.S. stocks will have outperformed international stocks for seven of the past nine years. However, for investors with a slightly longer memory, international stocks enjoyed a six –year uninterrupted streak of outperformance just prior to the financial crisis in 2008. So this begs the question, how much international exposure is appropriate in a globally diverse portfolio? Remember, asset allocation will be by far the most important driver of long-term returns. Most academic studies indicate that 90% or more of long-term returns are derived from the asset allocation, i.e. how much in stocks vs. bonds, what types of bonds and what types of stocks. For bonds, the key decisions are credit quality and maturity. For stocks, the key questions are U.S. vs. international, large cap vs. small cap, and growth vs. value factors. For our comments this month, we will focus on what is the right international exposure. One school of thought is to have a globalized portfolio with allocations to foreign and U.S. stocks and bonds mirroring their total global market values. The U.S./foreign allocations of global stock market indexes have hovered around 50/50 for the past several years. Over time, returns for U.S. stocks and international stocks have been similar, but foreign stocks have been more volatile. In addition, the cost of investing overseas tends to be higher, which can eat into returns. Finally, “home bias” plays a role as well as U.S. based investors care more about U.S. based indexes vs. international stock indexes.
For these reasons, we think less foreign stock than their total global weight seems appropriate. For a U.S. based investor, we believe the right mix is about 60-70% in U.S. stocks. We think international stocks play an important role in diversifying a portfolio as both markets don’t always move together. But because of the above mentioned factors, we believe U.S. based investors should limit their foreign stock exposure to 30-40% of their equity holdings. This should be enough to provide adequate diversification benefits.
For bonds, it’s more complicated. Even though more than 50% of the world's fixed-income investments exist outside the United States, investing in foreign bonds has the potential to add cost and volatility to a U.S. investor's portfolio due to currency factors. Remember, bonds can play two important roles in a well-diversified portfolio. They can be used to primarily provide income or they can be used as a volatility reducer to offset the risks taken by stocks. Regardless of their function, international bonds play an important role in diversification. But few asset-allocation experts are in favor of mirroring the global markets' allocation to U.S. and foreign bonds.
We suggest that international bonds represent no more than 20% of the bond portion of the portfolio. For example, if 30% of the portfolio is devoted to bonds, then international bonds would represent 6% of the total portfolio.
If you’re using bonds primarily to offset equity risk, then you should stick to mostly hedged international bond strategies, so you don’t take on added currency risk, which could erode returns and/or add more volatility to the mix. But if you’re willing to assume more risk on the bond side and can live with more volatility, then partially hedged international bond strategies could be appropriate. Within wealth management, we have a number of different international bond funds on our approved list, depending on the type of strategy that is appropriate.