My New Argument For 12.5% International Stocks/12.5% US Stocks in US-based PP

[TripleB]

I've been using and promoting a 50% US/50% International split within the stock portion of the PP for a while. It would be fine to use the World-Market Index Fund too, which is around 55%/45% but the ER is high so using separate funds is cheaper, and 50/50 is close enough and easy to rebalance to.

My main argument is to diversify against the US. In the regular US-based PP, an investor is 75% in US-denominated securities and 25% outside. In the event of a catastrophic government failure, all 75% would be at risk. While the US is tied to the global economy, it would be preferable to have a little diversification elsewhere. In my International-split PP, I am 37.5% non-US securities. That's 50% more non-US securities from a traditional PP, so I feel significantly more protected against catastrophic US collapse in spite of still being 62.5% US securities.

I am adding a new rationale to the discussion.

GIVEN the US is the global economic superpower, the US-based PP works fine. Considering other countries, such as a Zimbabwe-based PP, it would be ridiculous to put 75% in Zimbabwe-based securities. The primary reason that a US-based (or possibly even a Euro-based) PP works is because of the global power that the US (or possibly the UK or Germany) maintains.

BECAUSE the US is a global economic superpower, investors from other countries will invest money in US-based Treasury Bonds. During the Euro crisis, many Euro investors put money into US T-Bonds. Additionally, China and other countries have been buying US T-Bonds for a long time.

SUPPOSE there is an International Stock Market Crisis (which really did just happen). Those countries will take money out of their stock market, and invest it into "safe" long term bonds, such as US bonds.

THUS, if International Stocks decline in value, the US Treasury Bonds will increase in value, in the same way that a drop in US Stock prices will cause an increase in US Bonds.

FROM THIS LOGIC, I am not being too "risky" by putting half of my stocks into international markets because they are also inversely correlated with the US Treasury bonds that make up 25% of my overall PP.

In essence, this is a "free lunch" as far as the PP is concerned, because I get to hedge my downside risk (of the US collapsing) for an "expense" (the risk that international stocks will fail to match the US market) that is below a fair cost to me, because if the international stocks drop, I am still protected with US Bonds. Essentially, I am hedging my downside risk of this international position for no additional cost, because I was going to keep 25% of the PP in LTTs anyway.

While international stocks have dragged on my PP over the last year, I do not regret holding them, and my LTTs have gone up more than enough to compensate me.

[BearBones]

I get the logic, and you may be right. However, for purpose of discussion, here are two counterpoints:
1. You may not be not fully "hedged" against this very volatile and potentially overpriced asset. At current yield, will LTTs compensate for international stock market crash?
2. In diluting US stocks, there may not be adequate inverse correlation and volatility to carry PP when other components dip in times of prosperity.

Having said that, it is probably better than what I have done (separate VP with metals, energy ETFs, international equities, and no LTTs).

[WildAboutHarry]

There are a couple of sub-optimum aspects to holding international equity in a US-based PP. 

Currency risk, such that even if the international holdings perform well currency exchange rates will negate that performance in your currency.  Of course that can work the other way as well.

If you are holding international equity in IRAs/401(k)s you lose the ability to take any foreign tax credit.

If you really want to diversify US equity, why not international small cap or emerging markets?  Lower correlations to US total market.

[Gumby]

Currency risk, such that even if the international holdings perform well currency exchange rates will negate that performance in your currency.  Of course that can work the other way as well.

Agreed.

My main argument is to diversify against the US. In the regular US-based PP, an investor is 75% in US-denominated securities and 25% outside. In the event of a catastrophic government failure, all 75% would be at risk. While the US is tied to the global economy, it would be preferable to have a little diversification elsewhere. In my International-split PP, I am 37.5% non-US securities. That's 50% more non-US securities from a traditional PP, so I feel significantly more protected against catastrophic US collapse in spite of still being 62.5% US securities.

I think that's fine if it helps you sleep better at night. But, the truth is that a "catastrophic government failure" would also obliterate an international index fund. To start, a US collapse would freeze up global credit markets — sending all markets into a tailspin. Secondly, the fund would be unable to complete its transactions and transfer you its money in the case of a government failure (no Fed / ACH to settle transactions). Furthermore, unless you have an brokerage account that's actually denominated in a foreign currency — a Swiss brokerage account denominated in Swiss Francs, for instance — an International Index Fund would be just as inaccessible as your domestic fund.

In essence, this is a "free lunch" as far as the PP is concerned, because I get to hedge my downside risk (of the US collapsing) for an "expense" (the risk that international stocks will fail to match the US market) that is below a fair cost to me, because if the international stocks drop, I am still protected with US Bonds. Essentially, I am hedging my downside risk of this international position for no additional cost, because I was going to keep 25% of the PP in LTTs anyway.

Not really a "free lunch" when you consider the currency risk and inaccessible nature of electronic money during a global crisis. Of all the countries on the planet that are at risk of collapsing, the US is one the least likely to collapse. We aren't Zimbabwe. So, you're really just betting on a weaker dollar, when a stronger dollar could easily be in our future.

[doodle]

Today's companies are almost all multinational anyways so their earnings are all global. It is difficult to call McDonalds an American company and Toyota a Japanese company. Their products are produced and sold all over the globe and their workforce is selected from a global talent pool. In my mind neither company really has any national affiliation. By diversifying into an international index one is simply throwing the net out over a wider group of companies.....which should be a good thing overall. I also mix mid/small cap index into stock holdings instead of just going with a large cap approach a'la SP 500. I don't have data to back this up but it seems like a better approach.

Currency risk is overrated as an argument against international holdings. US companies in SP generate nearly 50 of earrings in foreign currencies and international companies probably generate close to that percentage of their earnings in us dollars....so overall holding international stock is close to a wash in terms of currency risk.

[steve]

Today's companies are almost all multinational anyways so their earnings are all global. It is difficult to call McDonalds an American company and Toyota a Japanese company. Their products are produced and sold all over the globe and their workforce is selected from a global talent pool. In my mind neither company really has any national affiliation. By diversifying into an international index one is simply throwing the net out over a wider group of companies.....which should be a good thing overall. I also mix mid/small cap index into stock holdings instead of just going with a large cap approach a'la SP 500. I don't have data to back this up but it seems like a better approach.

Currency risk is overrated as an argument against international holdings. US companies in SP generate nearly 50 of earrings in foreign currencies and international companies probably generate close to that percentage of their earnings in us dollars....so overall holding international stock is close to a wash in terms of currency risk.

Sounds like it would work but with more complications, and harder to rebalance. International, small, mid , large cap equals 4 indexes to rebalance and keep track of instead of just one like VTI. For a taxable investor my opinion is to keep it simple and only rebalance when you near or hit 15/35 band. The simplicity is part of the beauty and will probably give you a better return in the long run.

[Gumby]

Currency risk is overrated as an argument against international holdings. US companies in SP generate nearly 50 of earrings in foreign currencies and international companies probably generate close to that percentage of their earnings in us dollars....so overall holding international stock is close to a wash in terms of currency risk.

Not exactly...

Standard & Poor's informs us that, based on a full sample (100%), 24.58% ($2,288,479 million) of S&P 500 companies' global sales (~$8,720,000 million) came from outside of the U.S. in 2010. Based on a truncated sample (15%-85%) of the 255 (51%) S&P 500 companies that fully reported their foreign sales in 2010, 46.29% of global sales came from abroad
Source: http://seekingalpha.com/article/642141- ... and-stocks

So, the 50% figure is inaccurate and not representative of the broad index. S&P says the figure is really about 25%.

When you hold an international index, 100% of the entire index price is subject to foreign currency risk, in real time. But the S&P 500's 25% of currency risk through sales/earnings can often be delayed, hedged, adjusted, softened or contained depending on a company's structure. While I agree that all of the markets are pretty much global these days, there is way more currency risk by holding non-US indexes.

[doodle]

"riskier" could turn out to be heavy exposure to one currency.....only time will tell. Slightly broadening exposure to international currencies could provide less risk if looked at from a more traditional asset allocation approach outside of the PP. As equity markets tend to rise and fall together I don't think it is a terrible idea to gain access to major international companies who happen to list on foreign exchanges.

[craigr]

Just remember that US companies derive significant parts of their revenue from international sales. Think Coca Cola, Nike, Microsoft, Cisco, Intel, Caterpillar, Boeing, etc. So even if you think you have no international exposure because you only own US stocks, you actually have quite a bit. I've traveled to many countries at this point in my life and I'm telling you that US products and companies simply dominate just about everywhere. It is pervasive and even the tiniest village in the middle of nowhere is bound to have Coca Cola, running a computer that maybe is made by Dell, using the Internet on routing gear made by Cisco, etc. You'd be amazed at where you find American products being sold on this planet.

But if someone wanted to punt and just buy the Vanguard Total World index for their stock exposure, I wouldn't have a really strong argument against it except for currency risk. If they are OK with that then it's still a fine choice for stocks. 

[dualstow]

VTI = world excluding US
VTSMX = Total US
UDN = US Dollar versus a basket of currencies

Clive, I believe VTI is US excluding world. ;-) It tracks the MSCI US Broad Market Index.
You want VEU.

[Ad Orientem]

I think there is currency risk no matter what you do. Yes, adding foreign equity adds currency risk. But holding 75% in USD denominated assets also has significant risks. A few months ago Clive posted an excellent piece in which he opined that given the combination of a world economy based on fiat money and most of the industrialized states drowning in debt that the greatest long term threat was likely to be inflation. Conceding the added risk that comes with foreign exposure to equities, I think I am going to side with TripleB on this one. I am not a fan of VT because it over-weights the foreign and its ER is a tad high. But if you go 15% VTI and 10% VEU and just lump them together as "stocks" for rebalancing purposes I don't think the increased volatility will be unacceptable.

It's also worth remembering that the much discussed heavy foreign exposure of major US companies didn't help much during the period 2000- 2008 when foreign equity markets absolutely smoked the US Stock Market. Prosperity is probably the most currency neutral economic condition we have out of the four. So yea, there is currency risk. But I think it's not unreasonable for a little added diversification. For those who worry about whether LTTs will be enough to hold thing up in a deflationary environment if you own foreign equities then I would suggest maybe flavoring your LTTs with some EDV which as many have noted acts a bit like Treasuries on steroids.

[cowboyhat]

It may be the case that there is not one right answer to how much currency risk an investor should build into their portfolio because people have different amounts of currency exposure depending on what is going on outside their portfolio.

For example, if you have a gigantic dollar-based mortgage you might want to think hard before putting extra money in non-dollar currency. On the other hand if you make your living producing a dollar-priced commodity like oil a different logic might apply. If you have a large obligation or potential obligation in another currency you might want to hedge yourself very specifically.

Seems like holding a portion of stock allocation as international could offer some rebalancing profit opportunities in years that do not include massive global recessions.

[murphy_p_t]

This is an excellent discussion. I'm thinking of implementing something along these lines. In particular, I like the 50% US, 50% world idea.

Have any of your thoughts crystallized further on this subject?

[TripleB]

This is an excellent discussion. I'm thinking of implementing something along these lines. In particular, I like the 50% US, 50% world idea.

Have any of your thoughts crystallized further on this subject?

Yes, I still believe this is a viable solution if you want to index, however I'm leaning away from indexing my equity position at the moment. I've written about it in a few other posts but I'll give some examples why that are most pertinent to this international diversification discussion:

1) There's a lot of bigger internationally based, multinational corporations that make up the Total International Stock Fund that are also traded on the New York Stock Exchange that I can cheaply trade (and hold for the long term) in the creation of my own pool of 30 to 50 stocks. For example Toyota and Honda. Thus, I don't "need" to buy an international index fund to get international exposure (provided I am stock picking my own "index" of sorts for my equity position).

2) A lot of international (especially emerging) publicly traded stocks fall under the financial sector. I don't care to overweight financials (and in fact, I prefer to underweight them) so international indexing is less appealing to me than domestic indexing. Yes, 30% of the total stock market in an emerging country may be financials, so if you argue for market cap weighting then "only" being 5% financials (in my stock picking) doesn't cover the market appropriately, however consider that many businesses in international countries are either private or government owned. So 30% of the market is financials but only if you look at the publicly traded market. I don't want to put 30% of my money into what's publicly available, I want to diversify into different sectors as I see fit.

3) There doesn't appear to be good economies of scales in a lot of these companies. I read through the 10K for Delhaize (DEG on the NYSE) and they own "Food Lion" supermarkets in the US but 40% of their business is in 6 or 7 countries in Europe. They are traded primarily on a European exchange but also on the NYSE as an ADR. It's a silly investment in my opinion because you lose a significant opportunity when you spread across Europe. Look at how successful Wal Mart is, because they can build distribution centers and make their supply chain efficient. A grocery store chain that operates in 8 different markets with 8 different languages cannot gain that economy of scale, and in fact, probably has diseconomies of scale because now they need to employ 8 different managers for each country and different strategies are needed in each country so they add on managerial overhead whereas 8 different grocery store companies would not require the additional overhead as a unified one.

4) Many US Companies do business internationally, so you do gain international exposure just by owning some of the larger SP500 companies. If you stock-pick appropriately, you can select a basket of US based multinationals that operates disproportionately more internationally than the SP500 index and thus gain greater international exposure but through "safer" to hold US securities (regulated by the US government, which as flawed as it is, may be superior to many emerging governments).

All of that said, it's taking me a tremendous effort to implement a stock-picking strategy and it's unlikely I'll beat the index, and if I do, it won't be by much. I'm doing it because I want to and enjoy it. I dislike the blackbox idea of indexing and given the financial understanding to read a 10K, and the time to do it, I prefer selecting your own basket of stocks that you hold for the long term. At a certain point in the future if I decide to put less effort into investing, then I'll definitely go back to indexing and be OK with it.

[TripleB]

Additionally, I think the biggest opportunity for international equities that I'm interested in owning is Energy stocks because of the natural resources involved that are spread out internationally. I personally like VGENX, the Vanguard Energy fund. It's not quite an index, and it does have a bit of a higher expense ratio (0.34%) but still reasonable and they do something like 50% to 60% international energy companies.

Thus, for my money I like to pick and choose Consumer Staples, Financials, Industrials, Materials, Healthcare, all within the US exchanges, and then I will "index" Utilities with VPU (the Vanguard ETF) and "index" Energy through VGENX. I'm getting international exposure through US companies that work abroad (that I've hand selected) and through VGENX.