Whether it’s manufacturing, technology, trade, or retail distribution, globalization is the new normal. It’s the same with investing.
Carefully considered global exposure is an important part of any well diversified portfolio. We talked to Mr. Zilbering, one of the authors of a research paper entitled Vanguard’s framework for constructing globally diversified portfolios.
Here’s what Mr. Zilbering had to say about some of the important decisions you need to make when constructing globally diversified portfolios for your clients.
Vanguard: Tell us about the importance of a top-down hierarchy to portfolio construction.
Top-down hierarchy is exactly that. It’s about focusing on the most important aspect of portfolio construction, which is broad asset allocation and diversification. We know that picking a suitable asset allocation is the most important decision in building a portfolio
Studies over the years have shown that asset allocation is responsible for most of the returns, as well as the variability of the returns of a diversified portfolio over time. Our own Vanguard studies have also shown that over 90% of a portfolio’s return variability can be explained by its strategic asset allocation.*
The other 10%, including active investment decisions and market timing tend to have relatively little impact on return variability. 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. That approach can result in a portfolio that fails to meet their long-term investment objective.
Vanguard: Talk a bit about fund collecting.
Mr. Zilbering: Essentially, it’s 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 a client deciding to invest in a particular regional fund because he or she believes that region’s going to do well next year. Perhaps it’s picking a fund based on its star rating, which might be the most common mistake advisors see investors make.
Vanguard: For advisors who are looking to add an international component to their clients’ portfolios, what’s a good starting point, and what types of investments should they be looking at?
A good starting point for client portfolios that don’t already have allocations outside of the home country is to look at the global market cap. 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.
You can perform the same exercise 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. We believe a reasonable default option to do that and to invest in a global market cap index fund. It’s a low-cost way to get broadly diversified exposure to those global asset classes.
Of course, there are certain restrictions and some investors may have home bias or a preference for investing in their home country because there’s a comfort level there.
Vanguard: When you say “home bias,” is that exclusive to U.S. investors, or do investors generally have a natural home bias?
Mr. Zilbering: It’s definitely not exclusive to U.S. investors. In fact, the U.S. may have the least amount of home bias. For example, the U.S. represents about 55% of global market cap. U.S. investors hold about 79% of their equity portfolios in U.S. stocks, which is roughly a 50% overweight.
However, when 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%. That represents a substantial overweight to market cap, a much heavier allocation to their home country. We see similar trends in other regions around the world.
Equity market home bias by country
Notes: Data are in U.S. dollars, as December 31, 2015 (the latest available from the International Monetary Fund, or IMF). Domestic investment is calculated by subtracting investment (as reported by the IMF) in a given country from its market capitalization in the MSCI All Country World Index. Given that the IMF data are voluntary, there may be some discrepancies between the market values in the survey and the index.
Sources: Vanguard calculations, based on data from the IMF’s 2015 Coordinated Portfolio Investment Survey, Bloomberg, Thomson Reuters Datastream, and FactSet.
Home bias can result from several factors. Some of them are unintended because 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. These may include cost, liquidity, taxes, and regulatory limits. Investing internationally can be more expensive and taxes are part of that cost of preferential treatment for local securities. There are also regulatory limits in certain areas. You’re only allowed to invest so much outside of your home country.
Vanguard: Using the Canadian overweight example above, what’s the potential downside for that such a home bias overweight?
Mr. Zilbering: With respect to Canada there could be a particularly heavy concentration in certain areas—maybe in commodity type and natural resource market sectors. Not only is the portfolio now heavily weighted towards Canada, it’s also heavily weighted towards a specific sector of the market.
In the U.S., we’re fortunate enough to enjoy pretty broadly diversified markets. In fact, we’re pretty close to having broad exposure to various sectors. That’s not the case in many other countries.
Vanguard: Many U.S. investors argue that investing in American companies that do business abroad, such as Ford Motor Company, provides global exposure. Does that really provide true international exposure?
Mr. Zilbering: That’s a very common reason why some investors choose not to invest in international funds explicitly. They say, “I have multinational companies in my portfolio. That’s good enough.” However, 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.
Global equity market cap weights by region
Note: Data as of June 30, 2016.
Source: FTSE Global All Cap Index.
Vanguard: What advice can you give to advisors who are looking to help their clients overcome that natural home bias?
Mr. Zilbering: A good way to help clients overcome home bias is to reframe the international investing discussion. I like using the example of the automobile industry. 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?” Of course, none of us can answer that question. So why not invest in every company?
That’s essentially what we’re doing by investing outside of our country. Getting exposure not just to the Fords but also to the BMWs, Toyotas, and Peugeots. It’s about diversified exposure.
Some clients are not comfortable going fully market cap international. In that case, starting with limited exposure, say 20% internationally—is certainly better than having none. Ultimately, global exposure is unique to every client.
Vanguard: 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?
Mr. Zilbering: Obviously, maintaining an agreed upon asset allocation is the most important decision. I would suggest that an advisor spend time up front talking to their clients to identify their objectives, their constraints, and determine how much risk they’re willing to take. Finally, it’s crucial to stay on track and the way to do that is to rebalance the portfolio periodically.
Vanguard: Is the rebalancing phase a good time to reevaluate the client’s risk tolerance? Could that be the time to wade a bit further into the international markets and see if they’re willing to get closer to market cap?
Mr. Zilbering: That’s certainly a good practice. In fact, could be an opportunity to not just look at the stock/bond mix, but to see if the client is more comfortable shifting a bit further from their home bias and perhaps even adjust their sub asset allocation and get them shifted closer to market cap.
*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.
All investing is subject to risk, including the possible loss of the money you invest.
Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Diversification does not ensure a profit or protect against a loss.
The information presented in this article is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.
© 2017 The Vanguard Group, Inc. All rights reserved.