Swedroe: Int’l Diversification Is Free

Diversifying stock exposure internationally is a free lunch, so eat lots of it.

Today concludes our discussion on international stocks and whether investors should consider them in their portfolios. Negative tracking error has resulted in my receiving an increasing amount of calls questioning the wisdom of investing in international stocks.

To help you avoid making the mistake of recency, here are two questions to ask yourself:

First: While the economic news from the developed and emerging markets has been concerning, am I the only one aware of the news? If I’m not, which is surely the case, the negative news must already be embedded in prices. That’s why international stocks have done relatively poorly. It doesn’t tell me what they will do in the future.

Second: Do I really want to sell now at a time when international stocks are selling at discounts relative to U.S. stock—that is, they have lower price-to-earnings ratios multiples—and thus international stocks have higher expected returns?

For example, according to Morningstar, as of April 30, 2014 (most recent data available) the P/E ratio of the Vanguard S&P 500 ETF (VOO | A-96) was 16.7, and its book-to-market ratio (BtM) was 2.3. The P/E for the Vanguard FTSE All-World ex-US ETF (VEU | B-97) was just 14.4 and the BtM was just 1.4. And the Vanguard FTSE Emerging Markets ETF (VWO | C-90) had a P/E of just 11.4 and a BtM of 1.4.

The significantly lower valuations of the stocks in the two international indices indicate that while their economic risks might be greater, the market has priced in those risks, so they have higher expected returns as compensation.

With the facts and behavioral issues in mind, let’s examine why you might consider a higher or lower international allocations.

The following is from my book, “The Only Guide You’ll Ever Need for the Right Financial Plan.”

Reasons to Increase International Equity Exposure

• Reduced Risk: The historical evidence suggests that raising the international allocation to at least 40 percent reduces portfolio risk (volatility). For investors who have a substantial risk to the value of their labor capital, an allocation of 50 percent or perhaps even a bit higher may be appropriate.
• Investor Has Non-U.S. Dollar Expenses: An investor may live part of the year overseas, or frequently travel overseas. The investor should consider tailoring the portfolio to gain specific exposure to the currency in which the expenses are incurred. This could also be accomplished by making fixed-income investments in the local currency.

Reasons to Decrease International Equity Exposure

Costs Matter

In addition to the concern over tracking error, while international assets provide an important diversification benefit, international investing is more expensive because of higher trading costs, higher fund expenses and, for those investors who cannot hold their international investments in taxable accounts, the foreign tax credit (FTC) is lost.

As a rough estimate, if you must hold international stocks in a tax-advantaged account, the cost in terms of the lost credit might be 10 percent of the dividend yield. Also, the Vanguard Total International Stock ETF (VXUS | A-99) currently has a yield of 3.0 percent. Thus, the loss of the FTC adds an additional burden of about 0.30 percent.

Finally, we need to discuss one reason for having a low allocation to international stocks: the currency risk it entails—a risk for which there is no risk premium. However, this isn’t a good reason, because currency risk is actually a two-way, not a one-way street. There’s just as much risk of the dollar falling in value as there is that it will rise in value.

A falling dollar can impact your standard of living, acting just like a tax on imports, increasing their costs. It can even increase the price of domestically produced goods because the producers are now competing with more expensive imports.

Finally, even if a foreign currency falls in value, that tells you nothing about the dollar returns you might earn. For example, in 1956, the British pound was worth about $2.80. At the end of 2013, it was worth about $1.64.

Despite a nearly 41 percent loss of value from 1956-2013, U.K. small-cap stocks returned 15.2 percent in dollar terms, while U.S. small-cap stocks returned 12.5 percent. All else equal, a falling currency makes a country’s exports cheaper and its imports more expensive, helping both companies that export and those that compete with imports. And the reverse of course is also true.

There’s a second reason we need to discuss. While currency risk has increased the volatility of an all-stock portfolio, adding unhedged international stocks to a stock/bond portfolio hasn’t!

For example, for the period 1970-2013, a portfolio that was 60 percent S&P 500/40 percent five-year Treasury notes that was rebalanced annually returned 9.75 percent with an annual standard deviation of 10.98 percent.

A portfolio that was 36 percent S&P 500/24 percent MSCI EAFE/40 percent five-year Treasurys returned 9.87 percent and did so with an annual standard deviation of 10.87 percent.

Despite the currency risk, and despite the MSCI EAFE having lower returns (10.0 percent versus 10.4 percent) as well as higher volatility (22.4 percent versus 17.6 percent), the portfolio that included the allocation to the MSCI EAFE had slightly higher returns and slightly lower volatility.

The reason is that the annual correlation of the MSCI EAFE to the S&P 500 was just 0.66, and while the correlation of the S&P 500 to five-year Treasurys was just 0.03, the correlation of the MSCI EAFE to five-year Treasurys was actually a negative -0.16, providing greater diversification benefits. This example demonstrates why you should never make the mistake of considering assets in isolation.

The bottom line is that since diversification is the only free lunch, you might as well eat a lot of it.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.