Live webcast replay: The uncertainties and opportunities of international investing
June 26, 2013
Replay and transcript from a recent Vanguard webcast
Constant news of trouble abroad—China's slowed growth, Japan's economic woes, Europe's ongoing debt struggles—has led some investors to question whether the benefits of international investing are worth the risks.
In this live webcast aired June 6, 2013, Chris Philips of Vanguard's Investment Strategy Group and Beth Orford of Vanguard Flagship Services® explain why to consider international investments even during turbulent times, how emerging markets can play a role in your portfolio, and the diversification benefits of international bond funds.
Gary Gamma: Good afternoon, everyone. Thanks for joining us for this live webcast. Whether you're watching us on the East Coast, West Coast, wherever, and regardless of how you're viewing the webcast—from a computer, tablet, or smartphone—we're happy to have you with us. I'm Gary Gamma and today we're talking about international investing. If you're paying attention to the headlines, it may seem like foreign markets are more volatile than ever. But perception is not always reality. So let's tune out the noise for the next hour and discuss the uncertainties and opportunities that come with international investing.
After viewing this webcast, we hope you have a better understanding of why you should consider international investments, even in turbulent times; how emerging markets can play a role in your portfolio; and the diversification benefits of international bond funds. We have two experts joining us today: Chris Philips, a senior analyst in our Investment Strategy Group, and Beth Orford, our principal in Vanguard Flagship Services who came all the way from North Carolina for this. So thanks, both, and welcome.
Chris Philips: Thanks, Gary.
Beth Orford: Good to be here.
Gary Gamma: International investing is a popular topic. While international stocks have posted solid results in recent months, China's slowed economic growth and Europe's ongoing debt struggles remain key concerns for investors. These factors have led some investors to question if the benefits of investing abroad are worth the risks; and international bonds, a relatively unexplored asset class for many investors, [have] also sparked debate. We'll talk more about that a little later. But as you'll learn today, international investments, both stocks and bonds, can play a valuable role in your financial portfolio regardless of market conditions.
We'll get started by chatting with Chris and Beth, but if you've seen a Vanguard webcast before, you know the next hour is about you and your questions. Some of them have come in already, and I'm sure many more are on their way. We'll spend most of the broadcast answering those questions. You can also send in questions through Twitter by simply using the #VGLive. Does that sound good?
Beth Orford: It sounds great.
Gary Gamma: All right. Before we get into our discussion, we'd like to ask our audience a question. On the right-hand side of your screen, you'll see our first poll question, which is "Have you increased the international portion of your investment portfolio? If so, which of the following best describes why? 'Diversification,' 'inflation concerns,' 'to gain exposure to emerging markets,' or 'I have not increased the international portion of my portfolio.' " Take a minute to respond, and we'll share your answers in just a few minutes.
So while we're waiting for our audience to respond, let's talk a little bit about investors' concerns with international investing. Chris, would you like to start? What are you hearing?
Chris Philips: Sure. We do [have] a lot of conversations with clients, and we do a lot of research. And some of the core questions that we got recently have been not just around emerging markets and what the outlook is there, but if you've been a fan of the news or been paying attention at all, then obviously there's been a lot going on in Japan, in the Pacific region, that has raised a lot of eyebrows. There's been a lot of volatility in Japan. And then in Europe, the last four to five years, we've seen on-again-off-again bouts of crises with prospects of the euro breaking up, raising up various solutions, either being proposed or turned down. So there's been a lot of activity in the news, and investors have been asking a lot of questions about those activities.
Gary Gamma: Beth?
Beth Orford: I deal with many of our Flagship clients and it's very similar questions. They're reading the headlines and they're very concerned as to timing: "Is this a good time to be investing internationally?" And quite frankly, the fixed income side of international investing is a fairly new concept for many of our investors, so I'm sure that we'll be answering a lot of those questions in today's webcast.
Gary Gamma: Absolutely. Well, let's go ahead and take a question that we have right now, one from William in Bedford, Texas. William said, "You announced a new international fund; why should one invest in it?" Beth?
Beth Orford: Well, we've been in the international business for a long time. We've had international funds. They've all been equity international funds, however, and so those funds, Gary, as you know, invest in corporations that are overseas that are not domiciled in the U.S. They represent a significant portion of the asset allocation globally, and so we think for diversification benefits you should be invested broadly across the investment opportunities [around] the globe. And now, fixed income investments in those international markets is the newest fund that we are launching, and for the very same reasons: we think the benefits of diversification, the ability to dampen volatility in your portfolio, hold true on the fixed income side as well.
Chris Philips: And I would add—I think we actually do have a chart that will illustrate what Beth is talking about, about the size of these markets—and if we do show that chart, what you can see immediately is just how significant the global markets are. We do know that historically investors in the U.S. have been relatively reluctant to invest internationally, for whatever reasons, a variety of reasons, but what we also know is that more diversification tends to be better than less diversification. So we do encourage and we do push people to consider investing globally, whether it is on the equity side or the fixed income side.
Gary Gamma: Good. Well, I think we have some poll results that have come in now. Again, we asked you if you've increased the [international] portion of your investment portfolio, and the bulk is about 48% said that they have not increased the international portion of their portfolio recently. Then about 40% said that they have, and the main reason was "diversification." "Gaining exposure to emerging markets" was just 10%, and "inflation concerns" was just 1%. Does that sound about right to both of you?
Chris Philips: That's actually very encouraging. I think if someone is holding pat, ideally, hopefully they're holding pat at a reasonable allocation and not holding pat at 100% U.S. The fact that a significant majority have also increased their allocation for diversification purposes is exactly what we would encourage because, as we said, we want more diversification. We do believe that having exposure across global markets can provide that level of diversification, so I'm encouraged by those results.
Beth Orford: I'm the same way. I think those are great results. First of all, I hope that the 40-something percent that said that they have done nothing are good, stable, long-term asset allocators, and they don't get moved around by volatility in the markets or news headlines. And then I think the people who are considering adding to international exposure, they realize the benefits of diversification, so it's really encouraging. I agree with Chris.
Gary Gamma: Yes, excellent. We'd like to ask the audience another polling question, and this one is "In comparison to investing domestically, do you consider international investing to be more risky, less risky, or equally risky?" So again, take a second to respond to that, and we'll get back with the results. While we're waiting, let's move on to another question from our audience. Michael from San Rafael, California, writes, "The performance of emerging market bond funds seems highly volatile, even in U.S. dollar bonds. What is the expected volatility of the Barclays Index that the Vanguard [Total International] Bond [Index] Fund will be tracking?"
Chris Philips: Emerging market bonds are an interesting asset out there in the universe. When you think about emerging market bonds, they are bonds that are generally issued by emerging market countries. But when you think of fixed income, fixed income is generally classified as either high-yield or investment-grade. Now, one thing that we found in some of our research is that most of the emerging market universe is actually investment-grade, which may come as some surprise to a lot of investors, given the emerging market nature of the countries themselves. Now, if a country issues in dollars, that means they're issuing here in the States, and that bond is therefore not exposed to direct currency fluctuations. That being said, they are still more risky than your traditional fixed income investments, and they are very highly correlated to other risky assets such as equities, and particularly emerging market equities.
So these are things that you want to consider when thinking about emerging market bonds. In some of our research, we show that they're a little bit less volatile and risky than high-yield corporate bonds, which is also interesting to consider. But when you think about a risk spectrum and think about moving from a traditional, diversified, fixed income exposure in, say, something that's benchmarked to the Barclays Agg or a municipal bond fund—something that's more steady over time—emerging markets are definitely more risky, definitely more volatile. In 2008 they lost anywhere from 10 to 13 to 15%, so there is that prospect of volatility and loss that can be had there.
Gary Gamma: How do emerging market bond funds compare to just the international bond funds? Are there additional levels of volatility that you see there?
Chris Philips: Definitely, because there is more risk there. And the risk is primarily around whether the country can actually control their own inflation rates and can control their economic output and basically repay the debt that they've issued in dollars terms. So there are those considerations to think about when investing, and relative to the broad developed market that is almost all investment-grade, they are certainly riskier investments.
Gary Gamma: So probably—just a good point of clarification. I think we did get a question that says, "Maybe I missed it, but did you explain what regions are considered 'emerging markets?' "
Chris Philips: Emerging markets generally are defined as those areas or those regions of the world that are on the up-and-coming economic level. And so, if you think of the Chinas or the Indias, Brazils, Russias, South Africa, that type of country, that is emblematic of the emerging market world. There is a range, obviously, within developed markets. You have the U.S. You have countries like Singapore or Germany or the U.K. that are very developed, very advanced, and you have a range that goes down, even within developed markets, just like you have a range within emerging markets. I mean, you have some that are closer to the bottom end versus closer to the top end.
Gary Gamma: [Beth,] do you have anything to add to that?
Beth Orford: No. I think if you step back again, I think if we go deep on an emerging markets bond fund and we talk about that, we can describe some of the relative risks. But I think as a part of a whole of an asset allocation in a long-term, enduring asset allocation, it can make sense for lots of investors and it's because of—again—this volatility and the correlations that move inversely to other asset classes. Is that right?
Chris Philips: Yes, I would view emerging market bonds as something that might make sense if you are already a risk-seeking investor. So if you can tolerate risk, you can tolerate volatility, and you have an expectation that that volatility and that risk comes with a higher expected return in the future, then emerging market bonds can make sense. However, if you are a more risk-averse investor and more fearful of loss, then moving from an already diversified fixed income exposure in your portfolio is going to add more risks. And so you need to carefully consider whether that's a risk that's worth bearing in your portfolio.
Gary Gamma: Beth, Richard just sent in a question that says, "If one has not invested in international before, what's the best way to start?" I guess this could apply to both stocks and bonds.
Beth Orford: Yes, and I think it's a great question, Richard. I think that probably: start small, like with anything, and work your way in. On a balanced asset allocation, we think that international equities stocks should represent somewhere between 20 and 40% of a portfolio, with about 30% being the average suggested, recommended investment slice for an individual investor. But start at the lower end of that, and bleed in over time. See how you feel about that level of investment, and see how it dampens volatility potentially in the overall portfolio.
And then I think the same thing with bonds. We recommend somewhere in the area of, say, 20% of your portfolio, and we think it's best used inside a tax-deferred account because they're not as tax-efficient as, say, a municipal bond if you're in a high tax bracket (that should be in your taxable account). So let's start small. Try it out. See if you're comfortable with that level of investment.
Gary Gamma: [That] makes sense. Well, I think that leads into the poll as well. Obviously we're talking about getting involved with international investments slowly because of the risks that are there, and we asked if our audience considered international investing to be "more risky," "less risky," or "equally risky." About 67% said "more risky," and about 31% said "equally risky." Only about half of a percent said "less risky." So 31, 32% saying equally risky. Is that something that you talk about?
Chris Philips: It is interesting—I kind of smile a little bit because I hear this type of reaction a lot—and even if you look at Vanguard's website, we have our international funds at the highest level of risk. And generally if you look at one of those spectrums that goes from the low-risk to the high-risk, they tend to be out there with the small-cap funds and your sector funds and everything else. It does seem to fly in the face about what we talked about in terms of diversification, that if you actually have both U.S. and non-U.S. investments in your portfolio, you're going to have a less risky portfolio on average over time.
If something was, as a stand-alone, that much riskier, then you might not expect to have that type of result. So I think when you actually look at a specific region or a specific country investment, I would absolutely agree that you could have a riskier investment. Or emerging markets—it's higher expected volatility over time than developed markets—both on the bonds side as well as the equity side.
But we would generally view that international, broadly, does have a diversifying role. We do view them as having similar expected risks over time, with that possibility of diversification.
Gary Gamma: Let's take another question. Ray from Reston, Virginia, says, "What are the reasonable percentage allocations to international stock and bond funds?"
Beth Orford: I think we talked about that in the last question, and so, just to reiterate, we talk about being equally weighted. If we want to bring that chart up again, we can show how the globalization of the asset classes are—you can see that international bonds represents 33%, [international] equities 24%. So we would say, in some measure, you want to be close to the global market cap weighting. It all depends on the type of account you have, because locating your assets in the right accounts has tax benefits as well. But just to reiterate, our baseline recommendation for international equities is somewhere between 20 and 40[%], with 30% of your equity allocation in these kinds of international equities. And then on the bond side, 20% of your allocation inside tax-preferenced accounts—like IRAs or retirement accounts—would be a baseline recommendation. Would you agree with that?
Chris Philips: I would agree, particularly on the bond side. The biggest reason we say that is because we do want to have a priority when we think about what the preference is for holding assets in taxable versus tax-advantaged accounts. When you think about the value and the benefits of municipal bonds, particularly for the high-net-worth segment, there can be a much more powerful impact there for one's overall portfolio relative to the diversification benefits of an international bond fund. So in that case—and I think Beth would agree—we do view it as a more case-by-case basis in terms of what the "right" allocation might be for an investor on the bond side.
Gary Gamma: As I talked about in the opening, I think international bonds are still an asset class that has been unexplored by a lot of investors, and I think it's worth noting on that chart, as with an article recently on vanguard.com that Chris contributed to—you mention that international bonds are a major asset class, larger than international stocks, U.S. stocks, and U.S. bonds. So that's certainly something that we want people to be looking at and thinking about.
Chris Philips: Absolutely. It is the largest traditional asset class out there, and most investors have little—if any—exposure to it in their traditional portfolios. I think some stats that we have from the cash-flow and asset data that we see on an industry-wide basis says the average allocation is around 13% of assets. Now, that goes across individuals as well as institutions, and it's probably more on the institutional side, but there's a tremendous gap between what the asset class constitutes in the marketplace versus what investors actually constitute in their portfolios. That is a significant gap and we believe there is that diversification opportunity for a lot of investors.
Gary Gamma: A question came in from Frederick, up the road in Allentown, who said, "When you said 30% of your allocation to international equities, did you mean 30% of your total portfolio or 30% of the equity portion of your portfolio?"
Beth Orford: Thank you, Frederick, for that. To be clear, it's 30% of your equity portion of the portfolio [that] we recommend as a starting point for your international equity allocation.
Gary Gamma: Okay. Paul from Pittsboro, North Carolina, writes, "What international countries/regions do you recommend, and which ones to avoid?" Obviously a specific question, and we can't make any guarantees, but are there certain thoughts you have around that?
Chris Philips: I don't think our legal department would like it if we started guaranteeing or picking countries.
I think generally if you're familiar with how Vanguard talks about investing, we tend to—as Beth said—talk about investing in more proportional frameworks. So what does that mean? That means that we invest in what the market tells us. So if, hypothetically, emerging markets makes up 25% of the international segment, then we would say 25% of the international segment makes sense for emerging markets. If Europe is around 50%, then Europe would be around 50% in the portfolio. We look at something like the Vanguard Total International Stock Index Fund as a good proxy for what the international market constitutes. All the work that we've done on active investing versus passive investing, the difficulties of tactical allocations, the difficulties of timing and chasing returns, would show us and tell us that trying to pick those segments or those markets is extremely difficult.
And so we want to be invested internationally, first of all. Getting an allocation from, say, zero percent to at least 20[%], as Beth mentioned, is a big priority. But we want to do that in a broadly diversified framework. We want to have as much exposure to all the countries as we can.
This is pretty consistent across Vanguard, that we're not going to pick emerging markets and say, "We believe emerging markets are poised for significant out-performance over the next six months and therefore we're going to allocate a significant portion there." That's just not what we do.
Gary Gamma: And I think it's worth noting also that, given the chart indicated that 55% of the global market is overseas, we don't really recommend people holding 55% of their investments in international. Can you talk a little bit about where we come up with some of our general guidelines around what percentages people should be holding?
Chris Philips: Sure. We do know that there is a degree of home bias in a lot of investors' portfolios. Some is warranted. Some is more fear-related. I think we have really good material out there to talk about the diversification benefits of international investing, but particularly on the fixed income side, there are very real reasons—and Beth alluded to some of these—why you would actually want to have a significant portion of your assets in U.S.-domiciled investments, particularly municipal bonds. You can't get them internationally, one, and they have tax benefits here; and if hypothetically you're a New York investor, having a New York municipal fund can have a tremendously positive impact on your portfolio. Yes, it means that you're less diversified across the globe, but that home bias is very warranted.
We do believe there are rational reasons why one might back off that global market proportional allocation and think about what a more reasonable balance is between the opportunity for diversification, the higher costs of international investment that we know are out there, and the warranted rationale for particular home biases.
Beth Orford: Yes, and I would just add that I think there's an element of comfort level in your portfolio. So if you're going to worry every time you read the headlines, that if something's going on in Europe, I'm going to worry about my international exposure, then perhaps you might not be best there, because you may make the wrong decision at the wrong time and pull out. It gets back to: asset allocation has great benefits, but if you're going to stick to an allocation over time, that's terrific. If you're going to get too nervous, then maybe back off, trim back, or maybe not be in an international investment, if it doesn't fit your risk profile.
Gary Gamma: Drilling down a little bit on this question again is David from Hockessin, Delaware: "How much of my equity allocation should be in established markets and how much in emerging markets?"
Chris Philips: As I mentioned, we do believe in a market-proportional allocation, so whatever allocation the world has us at, for emerging markets versus Europe or the Pacific region, that's the amount that we would say makes a lot of sense. I don't have the stats right in front of me, but I believe emerging markets right now is around 25% of the non-U.S. marketplace for equities, so that's where we would have the portfolios positioned.
Gary Gamma: We have a little bit of a changed direction here. Ravingera, from San Jose, California, right next to my home town: "It is said that active management works best for international markets. Is that true? Is index investing not the best way to go for international investing?"
Chris Philips: This is interesting, and we actually just had a webcast a couple weeks ago on this idea of active management. I think we do want to be clear that we believe that active management can add value. The question is "Can we pick the right active manager in advance?" We've done a lot of work on the active/passive decision, both from an investor standpoint and a portfolio standpoint, and what we found is that there are a lot of considerations here. One is that the opportunity for out-performance doesn't necessarily mean that out-performance will be had. When you look at the statistics, passive does a very good job relative to the average active manager out there.
One of the big things that we see is not accounting for dead funds. So when you do an analysis around active managers, there are a lot of funds out there that die off. We did a paper a little while ago talking about these types of zombie funds and how they might work their way into traditional analyses; and what we showed was that once you account for those, passive wins a significant majority of the time, and consistently over time. The biggest challenge is trying to pick those active managers in advance, stick with them over time, and not react to the short-term events where one might significantly underperform.
Beth Orford: I would also add that the cost is a factor. So an active manager at a reasonable price, and I think that's the role that Vanguard serves, is we have a stable of active managers and we offer them at a very competitive price, and that changes the landscape, right? When you compare active to passive, you've got to compare after costs, and the higher the costs the active manager charges, the lower [the] opportunity for the investor to win in that scenario.
Chris Philips: Absolutely. We do believe that cost is the biggest driver of relative success over time, and it is one of those things that you, as an investor, can control. We can't control what the euro's going to do. We can't control what the pound is going to do. We can't even control what the dollar's going to do, and we live here. But you can control the costs that you pay. What we at Vanguard try to do is give you access to top talent around the world at a very reasonable cost, and by doing that we think that we can give you the best chance of all the active funds out there, of performance and of realizing that performance. But I would also add that when we think about the taxable nature of active funds, that can be a very significant driver of an investor's performance relative to passive as well, because you just never know if the manager is going to all of a sudden fall out of love with a name that has had tremendous capital gains, and all of a sudden you get a distribution if they sell. And that type of tax bomb is something that we don't encourage to have in taxable registrations, particularly for high-net-worth investors, because of the unknown.
Beth Orford: And other costs.
Chris Philips: Exactly.
Gary Gamma: We talk about the cost impact on investing. Is it fair to say that with international investments you tend to see higher costs—so that could even become an important factor in international investing?
Chris Philips: Exactly. Now, they've certainly come down over time. And while costs are higher, if you compare [Vanguard] Total International Stock Index Fund to [Vanguard] Total (U.S.) Stock Market Index Fund, they're both, I believe, sub 25-basis points, but the international fund is still going to be higher in a relative sense than the U.S. fund. There's still a very low cost relative to the other options in the investment world, but the international fund is higher-cost than the U.S. fund. So that is something to consider, and then you also have frictional costs, you have whatever bid-ask spreads are on, say, a Swedish security that might be wider than a comparable security here in the U.S. So there are other costs that are embedded in the portfolio itself.
Gary Gamma: We have a question that just came in from Sharon in Avon, Indiana, that says, "What is the name of the fixed income international fund?"
Chris Philips: If I don't get it completely wrong, I believe it is our [Vanguard] Total International Bond Index Fund.
Beth Orford: That's the broadest one, and I believe that's right. And then there's the emerging market—[Vanguard] Emerging Markets [Government Bond] Index Fund—that we came out with, too. They're new funds so forgive us if we don't have the names exactly right. But [Vanguard] Emerging Markets [Government Bond Index Fund] is the more narrow; it just invests in emerging markets. Then the [Vanguard] Total International Bond Index Fund is the more broadly diversified fund.
Gary Gamma: Another question, Ira from Minneapolis: "Wouldn't it be wiser to wait until the markets in Europe and other areas start rising, even though that is a tough call to make? Isn't it unwise to invest now and likely earn very little over the next several years? Why not wait?" Beth?
Beth Orford: Yes, it's interesting. It's the age-old [issue of] market timing. You can apply that question to international, you can apply it to domestic U.S. bonds, anything. I think the hard part about that is you've got to get two decisions right. You have to know when to go in, and when to pull out, and most of us are not smart enough to make those decisions. So we believe in being broadly diversified. If Ira is nervous about it, you can consider dollar-cost-averaging into these markets over time, and that just means that you put a portion of your investment in over, say, a monthly or quarterly period, until you are fully invested at the level that you want to be invested. But we just don't have a crystal ball, and it's not very clear to us when the best time to invest is, and we believe in this long-term asset allocation.
Chris Philips: One thing I would add is we did a publication earlier this year called Vanguard's Principles for Investing Success, and there's a very interesting chart in that paper. The chart looks at the performance of flexible allocation funds. Now, flexible allocation funds, according to Morningstar, are those managers that are able to change their allocation over time, whether it's between U.S. and non-U.S. or whether it's between equity and fixed income. Basically it's their objective to change their allocations over time to offer either more consistent performance or better performance than what their static benchmark might have. If you look at what the results from that table actually show, it shows that these professional managers, whose job it is to time the markets successfully, have not done so. They have not done so in either bull markets or bear markets. They've not done so consistently over time. There's a tremendous amount of variability with how one manager does in one period versus the next period, or how managers across the board do across all the periods.
And they're the ones that have all the tools, all the data, all the context, tremendous capacity, and economies of scale, and yet they fail to succeed consistently over time. So I would say if it's so difficult for professionals to do it, what might seem intuitive—"Well, of course, we'll just wait until Europe turns around, then we'll invest"—it can be extremely difficult to consistently meet those lofty expectations over time in a real-time environment.
Beth Orford: In some cases, it's because that performance comes in very short spurts. Isn't that right, Chris—where there will be times where markets will appreciate very quickly in a short period of time. So you've got to sort of catch the wave, and it's hard to do that.
Chris Philips: All you have to do is look back to 2009; the bottom of the global financial crisis bear market was March 9, 2009. Over the next month-and-a-half, the U.S. markets, and global markets as well, rose a significant amount, and over the next two years—I'm ball-parking numbers here—but anywhere from 50 to 60% of the total return of the following two years happened that first two months. That's what Beth's talking about. So if you missed that, then you've missed a significant portion of that total return. That really gets to why timing can be so difficult.
Gary Gamma: People who tend to make market timing moves are not apt to jump back into the market and get that recovery, right? They're probably going to sit on the sidelines and watch.
Chris Philips: And the other point I would add is when you think of Europe specifically, our chief economist over in Europe has basically laid out several probabilities, several paths for Europe to follow. One, everything could be fine, everything could be hunky-dory and Europe could rebound. You could have the status quo and kind of a muddle-through environment. Or you could have something where you actually see a euro break-up. Now, if you buy into any of those three outcomes, the ideal investment is completely different. So if you're in path one, then you want to be a euro investor today, because you have the high expected returns. If you're in path three, you basically want to be in all U.S. treasuries, because that would be a massive dislocation dysfunction in the marketplace.
But the probabilities of getting path one, two, or three, and then having it be right, and then having the timing right to get in, is extremely difficult to do.
Gary Gamma: And this question, while we were talking about it in the international way, is really just an extension of what people are dealing with right now in the American markets, too. I meet with investors every day and they're constantly asking, "Should I be in stocks or bonds right now?" So this is just a natural inclination, to apply that to the international.
Okay, Frank from Sacramento, California, says, "Many large-cap companies are global. Won't holding total stock market index funds give a reasonable international exposure?" What do you think about that one, Chris?
Chris Philips: We've done some work on this idea of globalization and this idea of multinational companies. What we found is that if you're investing in only the GEs and the McDonalds and the United Airlines of the world, that, yes, they have operations globally, [but] you don't have access [to] and you're not investing in actually foreign-domiciled firms. And so you are leaving out a significant portion of the global pie. As we showed [in] that chart from earlier, international stocks make up a significant portion of the global allocations, so you do get some exposure certainly, to revenues that GE might acquire from their international investments, but you don't get that direct exposure to foreign markets. I think that is something that you definitely should consider.
The other point that I would add on—and this is more for the technical, savvy people, more interested people in the audience—is that most of these businesses apply currency hedging techniques within their own book of business. GE wants to manage currency fluctuations of their own business portfolio, and so they're going to be operating in the currency markets to get rid of as much of that volatility as they can. So you might not actually be getting the diversification benefit of true foreign exposure, because the businesses themselves are getting rid of a lot of that in managing their own balance sheets.
Beth Orford: Yes, I think that's right. I think that we get this question from investors all the time: "If I own General Electric, if I own Apple, Apple's operating all over the world—am I not getting enough diversification?" And I just go back again to the question of "How comfortable are you going to be?" There are some very, very big names—Toyota or Nokia or lots of household names—that exist and are domiciled outside the U.S. And so it really gets to comfort level. I think there's a case to be made—if you're going to be too nervous about it—there's a case to be made for staying in the U.S. as well.
Chris Philips: Absolutely.
Gary Gamma: Okay. We have a question from Sheila: "Going back to the question of relative risk involved in domestic versus international investing, would you not agree that foreign exchange risk and political uncertainty make domestic investing relatively less risky?"
Chris Philips: I think that is a great question, and what we do know is that foreign exchange risk does, on average, impact the volatility of foreign investments over time. It has to. That is a mathematical certainty. What we also know is that those currency movements do have the ability to diversify the overall portfolio risk on the equity side. So that is something that we want to factor in. As a stand-alone investment, yes, if you only have international securities in your portfolio, you do have added volatility because of the foreign exchange risk. There certainly is some political risk, I think, when you look at a country like China. If we're talking about emerging markets in a country like China, it's still a Communist regime, right? There still is the possibility that China could nationalize foreign assets, just because they want to. You just have to go back to the late '90s to think about what happened in emerging markets, whether it was the Asian contagion or the Mexican peso crisis. Argentina over the last couple of years has nationalized a Spanish firm. So there is this political risk that is pervasive in the international world, but it's not something that I would look at to drive you away from international investing, because we do know that it tends to be isolated and episodic, and when you do combine that in a portfolio, on average over time we would expect there to be some diversification benefit.
Beth Orford: That's right.
Gary Gamma: Well, the next two questions actually are on a similar theme. Down in the weeds a little bit, we have a question from Keith: "Why are your international bond funds currency-hedged? What if I seek foreign currency exposure as a diversification?" And then the next question, from Robert: "Is investing in foreign currency a good investment strategy? If so, what are the best ways to go about doing that?" So two similar questions about currency.
Chris Philips: It is interesting, and this was not a set-up at all, but I did pick my words very carefully when I talked about the benefit of currency investing. I was very particular to stay on the equity side, because on the fixed income side we actually have a very different view. On the fixed income side, what we have shown in some of the research that we've done is that basically any exposure to currency on fixed income overwhelms the diversification benefit of that currency exposure, because the volatility of currency is so much larger than fixed income itself. If you think about the average bond fund, [with] an average volatility of around 4%—well, currency, on average, the volatility is anywhere from 9 to 10%. So that volatility basically increases the risk of your bond fund pretty dramatically over time, to the point where our research showed that any allocations to unhedged foreign bonds increases the risk and increases the potential for a loss in a diversified bond portfolio.
Now, if you're able to hedge that out effectively over time, we actually showed the exact opposite, that you do get those diversification benefits. So it is a very, very different story when you move from equities to fixed income. There's a lot more math behind it all, but that's your, I'll call it a five-thousand-foot version of this story.
Then [with] regards to currency investing itself, a lot of our views on currency basically come back to the idea that we believe currency is a "random walk," and we believe that currency is a zero sum game, and that there's no tangible benefit or expected return for taking on that risk in a portfolio. And that's if you're talking about a basket. Now, there are a lot of economic analyses out there that look at one currency versus another currency; that's not what I'm talking about here. I'm talking about if you're looking at total international investing, a basket of currencies. It is what we would call an "uncompensated risk," and so from that standpoint we don't see there being a tremendous value added to taking on an explicit currency position in a portfolio.
The last point I'll make around this is that if one does have a negative view on the dollar, because of the volatility impact on the bond side, I would simply say if you have a view on the dollar and it is very pessimistic, increase your international equity allocation. They're unhedged. They have exposure. We believe there's a diversification benefit there, and by going from, say, 20% non-U.S. stocks to 40% non-U.S. stocks, you just increase the exposure to foreign currencies in your portfolio.
Beth Orford: And I might add one more thing. We believe that the bond portion of your portfolio should not be where you take on excessive risk. That's the ballast, right? That's the area of your portfolio where you want the dampening of volatility, the lowering of risk over time. That's the benefit. You get a smoothing [of] returns so you can stay the course in your asset allocation in your portfolio. If you want to take on an extra risk, we see that really happening on your equity side.
Gary Gamma: Bonds [are] not the place to make your currency plays.
Beth Orford: That would be my advice.
Gary Gamma: David from Glencoe, Missouri: "What is the difference between emerging markets and frontier markets?"
Chris Philips: Earlier I touched on that range of development in the global world. When you think about what a frontier market is—I actually just recently referenced Argentina—Argentina is actually defined as a frontier market. So a frontier market is a market that has a lot of structural issues in terms of investability. Now, in terms of economics, Argentina is actually a pretty developed country, but in terms of market structure, freedom of capital, ability of foreign investors to actually invest in Argentina, it is very—
Beth Orford: Transparency.
Chris Philips: Transparency. Costs. Legal and accounting structures. There are a lot of these financial market indicators that one has to consider, and that's the general profile of what a frontier market might look like. You've got a lot of countries in the Middle East, you've got a lot of countries in South America, you've got a lot of countries in Africa. And that's the profile of a frontier market: very illiquid, very non-transparent, high costs, and very subject to a lack of investor protections.
Gary Gamma: We have a question from Susan, Santa Rosa, California: "I've read that international funds should be in a taxable account for retirement because of the foreign tax credits and the volatility; sell the losers. Is this always a good strategy?" Beth, do you want to try to break that question down a little bit?
Beth Orford: Actually, we think about this slightly differently than Susan. We think that if there are funds that will throw off more current taxation—either through dividends, distributions, capital gains—we would want to protect those in tax-deferred accounts now. We think that over time you get a better benefit from reducing your tax bill currently than [by] trying to then time it. It's sort of another timing decision. What's the best time to get in and out, waiting for tax credits?
Gary Gamma: Question from Carmen from Amarillo, Texas: "Please discuss current correlation of international asset classes with domestic asset classes." Chris?
Chris Philips: I'll touch on equities first; then I'll touch on fixed income. On the equities side, correlations are very high. We're still very much in a risk-on, risk-off environment, and so you do see things tending to move more in lock-step today than, say, even 15 or 20 years ago. That being said, correlation is not the be-all-end-all of diversification. And so you could hypothetically have one market that is off by one percent (negative 1%), another market that's off by 10% (negative 10%), highly correlated—actually perfectly correlated—but there's still a massive diversification benefit from having a combination of the two. (If you did not note it, one was going to be off 1% and one was off 10%.) I do try and steer people away from this idea that we have to only look at correlation in isolation to determine the diversification benefits of one asset class or another security to something else, because while things have been moving more in lock-step, there is still that absolute difference in returns over time that we do need to consider.
On the fixed income side, again, some of what our research has shown is that that correlation— that increase in correlations—has actually not gone to the fixed income side when you talk about a hedged portfolio. Even in the last five years, the long-term correlations are still very relevant today, so today's correlation is still very reflective of the long-term average correlation between U.S. and non-U.S. hedged securities.
Gary Gamma: Brian writes, "Discuss the risk and transparency associated with investing in international bonds."
Chris Philips: Yes, so we have discussed some of the risks. I think some of the considerations one might have [are], if your traditional view has been for the U.S. market—I'll just use the Barclays Aggregate or the benchmark that our [Vanguard] Total Bond Market Index Fund is benchmarked to—there's a pretty good balance between government securities, corporate securities, and mortgage-backed securities. That balance isn't necessarily true globally; globally it's much more sovereign or government bond exposure than corporate bond exposure. If you think of what the international marketplace looks like, it's generally historically been a bank-loan driven market, so a lot of firms will go to banks for financing as opposed to issuing debt themselves. So it's primarily government-based. That's one consideration.
There are duration differences over time, and there are some yield differences over time, between U.S. and non-U.S. bonds, when thinking about the overall portfolio characteristics. I wouldn't be as concerned about things like political risk or transparency. The international bond market, because it is sovereign in nature and is mostly government, is very liquid, it's very transparent. Compared to something like the municipal bond market, which is probably one of the most fragmented, illiquid markets in the world—and we're very comfortable operating there—the international bond market, especially on the developed side, is very transparent and very liquid relative to that more fragmented market.
Beth Orford: And in fact, Chris, don't we highlight in one of our papers that over the past decade, or maybe decade-and-a-half, the international fixed income markets have been enabled by technologies and therefore have become more transparent, more friendly to investors, which is why we feel comfortable bringing out an investment at this time.
Chris Philips: Absolutely, and the costs to invest internationally have dropped dramatically over time as well, which is another key consideration.
Gary Gamma: Do we have concerns about what's going on with the European Union? Will it stay together, what are the impacts, something like that?
Beth Orford: Well, I think we have; as Chris mentioned before, we've got three different scenarios. "Concerned," that sounds very strong, but we certainly want to be aware of the different scenarios and probabilities and therefore be advising our clients on how to allocate their portfolios in line with that. I think that it's a probabilistic "everything will be fine," "euro will break up," and then there's something in the middle that's sort of this "bump along" scenario.
Chris Philips: Yes, I would agree. I think we certainly want everyone to be aware of the news, and be aware of what's happening. We don't want to put our head in the sand and just forget about everything, even if that might be the best strategy over the long term—just completely ignore everything. We want people to be aware, because we do believe that information can be helpful over time. But where we do draw the line, at least for our own positioning, our own views, our own discussions with clients, is trying to take that awareness and make something of it, with a portfolio allocation or a change in how we allocate assets. The most important piece of information, I always tell people, is what happens next, and no one knows what happens next. We only know what has happened, and there have been any number of scenarios here in the U.S., whether it was the downgrade of the Treasury or fears over inflation or fears over the dollar, fears internationally with the euro, with China slowing down, with the yen and the Japanese central bank recently. These are all scares that happened that can basically be considered unpredictable.
And then even if we could predict them—I'll use the U.S. Treasury downgrade as a perfect example—even if you could predict that, the outcome is exactly the opposite of what everyone who would've predicted it would have expected. The Treasury actually rallied after it got downgraded, which is completely the opposite of what you would expect. So even if we did have massive concerns about the euro—and I'll be honest, the euro break-up is one of those big scenarios that we look at that could be a huge hindrance in global economic growth or continued global economic growth. Things like the deficit here in the U.S. and having a structural deficit for the foreseeable future—those are the big macro events that we see as big potential stumbling blocks. But we're not going to focus our investment strategy on trying to isolate one or two factors that we just don't know, with 100% probability, that it will happen.
Gary Gamma: What about Japan? We saw them back in the '80s obviously riding high. They've sort of been trying to get back since then. For international investors, I often hear people talking about Japan and whether or not that's a legitimate place for them to invest. Do you have any thoughts around that?
Chris Philips: I think when you do think of the global portfolio, Japan is part of the global portfolio. And so, to exclude Japan is to take an explicit bet against the collective wisdom of all global investors. That's basically how you can think of what the market allocation looks like. If you over-weight Japan, then you're placing a bet on Japan in the face of all collective investors globally. So we do view Japan as having a role in a portfolio; it has a role that's equal to its market capitalization in that portfolio. In terms of economics or in terms of the interest rate environment or the banking environment in Japan, there have been any number of potential solutions. I think the one good piece of information has been that the central Bank of Japan has basically said they're willing to try everything they can, which is a little bit of a divergence from their past paths in trying to solve the issues going forward. But the other piece of good news is that the U.S. was feared to actually be following the path of Japan. I think that some of the trajectory that we've seen in terms of economic growth will clearly put us in a different path than Japan.
Beth Orford: And I think another factor that our research has brought out is that sometimes the GDP of a country does not necessarily correlate to the stock market performance of that country or of individual investments in that country. And so we think that, again, global asset allocation makes a lot of sense because it does not necessarily follow these dire or grim GDP predictions.
Gary Gamma: Another question, from Michael in Seattle, Washington: "Relative to the outlook for corporate earnings, how are non-U.S. equities currently priced: seemingly too high, low, or about right?"
Chris Philips: It's all relative. Let me preface this by saying that we do know that earnings, and specifically the PE ratio (the price-to-earnings ratio) is the best metric for trying to gauge a security's or a market's future potential, of all the metrics you can look at. Whether it's GDP—as Beth alluded to—or inflation or the Fed model, all these other metrics we've looked at, the PE ratio tends to be the best tool to actually try and have some reasonable guess about what the future return might look like.
That being said, it's still very, very noisy. In the short term, in say a one-year frame, there is no information at all, so you could have a PE of 5 and a one-year return that could be negative; or you could have a PE of 40, like we saw in 1998, and a return that was significantly positive. On a ten-year basis, it changes a little bit, but even then there's still more unexplained noise in the information than explanatory power.
So I think this is all important to gauge, when we're talking about relative valuations. When you look at a market like the U.S., and I know the question was on international, but when you look at the U.S., the PE ratio has changed over time. We've seen basically a one-directional market this year, which, all else equal, will raise the PE ratio.
Does that mean we should then scale back? Again, if there's no information in the short-term, then that can be a very dire consequence if hypothetically we continue to appreciate over the rest of the year. Why I say that is that if you look at what's happened with emerging markets, emerging markets—[in] the last year, year-and-a-half—has significantly underperformed both the U.S. and developed markets worldwide.
As a result of that, emerging markets actually have valuations that are pretty attractive relative to other valuations internationally. That means absolutely nothing in the short term. Now, if we as investors can invest and we can invest internationally and take part in emerging markets alongside of developed markets, and maintain that investment for the long term, then there might be some merit there. But even then, as I said earlier, there's still a lot more unexplained power than explanatory power, even in the PE ratio.
So, again, I think in the vein of knowing what's out there and being aware of information, we definitely want to be informed about what the valuations look like. But we don't want to hang our hat on trying to say that, "Well, Europe is a screaming buy" or "Pacific is a screaming sell" because there's a discount in Europe relative to the Pacific.
Beth Orford: And I think some of those moves then turn damaging, ultimately, to clients' portfolios, either because they don't get the timing right or because they're introducing more costs through either trading costs, tax drag on the portfolio, so you really have to be careful with those short-term moves.
Chris Philips: Especially now with ETFs. While most of our high-net-worth investors are commission-free with ETFs or only using Vanguard ones, there are still bid-ask spreads. Bid-ask spreads—every time you make a buy or sell, you're going to be hit by that, and so that is a very real cost to trying to implement one of these strategies. While you might see either a short-term gain or a loss in that strategy over time, that bid-ask spread can drag down your average performance rather than just staying pat.
Gary Gamma: I think we got most of the questions. Before we start wrapping up here, I think it's probably important to mention to our audience, I was doing some meetings in Michigan last week and talking to some investors who had targeted retirement funds, and they were unaware that the [Vanguard Total] International Bond [Index] Fund was being added to that fund. So I think it's a good point to make, that Vanguard is adding these funds and has added these funds, to the [Vanguard] Target Retirement Funds, the [Vanguard] LifeStrategy Funds, I believe the [Vanguard] Managed Payout Funds. So for investors that are just using those instruments, should they consider what we're doing in there to be adequate?
Beth Orford: I would just say I think those are right for a lot of clients in the right accounts, because sometimes there are tax implications that you have to be aware of if you're holding them in a taxable account. That's one way to go. I also would introduce to the clients, if they don't already know, that Vanguard has, for retail investors, several different ways to get advice from Vanguard and guidance on how to asset-allocate. And when you start throwing in international bonds, international stocks, domestic asset classes, it could be confusing for people as to "How do I go about implementing all these great ideas in my portfolio?"
Chris Philips: I would also add, particularly with the high-net-worth crowd, that when we think of who the [Vanguard] Target Retirement Funds are right for, it's basically: if I know nothing about you other than your retirement date or your current age, it's a baseline portfolio for you to consider. But with high-net-worth investors, they tend to have a lot more considerations beyond just that total portfolio solution, so I think it might be a place they can look at to get a good gauge of how we think about global allocations. I think, to Beth's point, having that conversation with someone can really drill down on what the true needs of each client are and then how each asset can actually fit in a portfolio.
Gary Gamma: I'm sure we could go on for a long time, but we're running out of time. So thank you both for your insights here. Beth, any final thoughts on the topic here as we wrap it up?
Beth Orford: I just think that there's a lot of research, there are a lot of papers that are very consumable on our website, and so learn more about this so that you can be a comfortable and confident investor. While international bonds, for example, or equities, may not be ubiquitous in people's portfolios, it does offer some diversification benefits, and so I tell people to learn more about it and seek help. If we can help them, we'd love to.
Gary Gamma: Chris?
Chris Philips: I've talked a lot already, so I'll keep it short and sweet. I do believe that more diversification is better than less diversification. And I think that if I could encourage people to do one thing, it is try and look beyond the headlines and think about the longevity of the portfolio. Think about what the overall goals of the portfolio are and how having that global diversification can basically help them achieve their goals over time, relative to a U.S.-only portfolio.
Gary Gamma: Excellent. Well, thanks to you both for coming. Appreciate it, especially for [Beth] coming from North Carolina. Have a good trip back down there. From all of us here at Vanguard, we'd like to say thanks for joining us this afternoon. In a few weeks we'll send you an e-mail with links to highlights of today's webcast, along with transcripts for your convenience. And if we could have just a few more seconds of your time, please respond to a quick survey that will appear on the right-hand side of your screen. We appreciate your feedback and welcome any suggestions about future topics you'd like us to cover. Again, thank you so much for being with us and enjoy the rest of your day.
All investments are subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issues by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. These risks are especially high in emerging markets.
Total International Bond Index Fund is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The Fund will incur expenses to hedge its currency exposures.
The Emerging Markets Government Bond Index Fund seeks to track the performance of an index that measures the investment return of dollar-denominated bonds issued by governments of emerging market countries (including government agencies and government-owned corporations). Because the Fund invests only in U.S. dollar-denominated bonds, U.S.-based shareholders are not subject to currency risk.
Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
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