Markets & Economy
Investing abroad: Risks, rewards, and realities of international markets
April 10, 2014
Akweli Parker: Hello, and welcome to Vanguard's Investment Commentary Podcast series. I'm Akweli Parker. In this month's episode, which we're recording on March 17, 2014, we'll be talking about global investing.
The high-stakes standoff with Russia and Ukraine currently sits atop a long list of events contributing to instability in global financial markets. The volatility these events create has to prompt some investors to wonder, is it safe to invest outside my home country?
Here to help us examine that question and to make sense of international equities and bond investing is Chris Philips, who is a senior analyst in Vanguard Investment Strategy Group.
Chris, welcome to the program.
Chris Philips: Thanks, Akweli.
Akweli Parker: Chris, Russia and Ukraine are just the most recent examples of geopolitical tensions causing volatility in foreign financial markets. For investors confronted with such an obviously greater volatility risk, why even consider foreign securities as part of their portfolios? What's the upside for them?
Chris Philips: Well, the upside is diversification, but I think beyond that what you do get is we have to have risk in our portfolios in order to generate returns. That risk is going to flare up from time to time, and this is one of those times where it does flare up and it's very noticeable in its execution in the portfolio. But we do want to maintain that ability to diversify our portfolios over time. So we don't want to view the instability/uncertainty worldwide as a cause to reduce exposures to global securities within the portfolios as we currently have them.
Akweli Parker: You recently published a white paper called, Global equities: Balancing home bias and diversification. In it, you said, The economies of "other developed countries are less than perfectly correlated with the U.S. equity market." What does that phrase mean exactly, and why is it a potentially attractive feature for investors seeking to benefit from diversification?
Chris Philips: Well, correlation is a statistical measure in the mathematical sense of it. But what it actually means for an investor or an advisor is that, if the German economy isn't moving perfectly in sync with the U.S. economy, then having some exposure to those securities that are driven by that economy can diversify the returns of your domestic securities. And we do see that worldwide—that benefit of having that differing exposure over time.
Last year would be a good example of that, where the emerging-markets segment of the world actually dramatically underperformed the U.S. and Europe or the Pacific. That's a lack of correlation in the marketplace.
Now, you don't want things to go down, but that's the reality of the investing world, right? So that correlation benefit does lead to diversification. We do want exposure to global securities worldwide because of those benefits.
Akweli Parker: You also wrote that, despite the size of non-U.S. markets, U.S. mutual fund investors held, on average, only 27% of their total equity allocation in non-U.S. domiciled funds. What do you think accounts for this home bias in U.S. investors?
Chris Philips: I think, first, it's important to say that if we looked at this ten years ago, that number would have been closer to 20. The fact that investors have increased their exposure to non-U.S. stocks, I think, is a very good thing. But there are many reasons why investors might maintain what we call a home bias, a desire to have more exposure to their own securities. There are some rational reasons, but mostly it comes down to the behavioral aspect and that, "I just like to invest in what I'm comfortable with and what I know."
Akweli Parker: Hmm, that's quite a revealing insight into investor psychology.
Since we mentioned Russia and Ukraine in the intro, perhaps we can talk about the differences between emerging and mature financial markets. Can you talk about the potential pros and cons of investing in each one?
Chris Philips: Obviously, the biggest pro would be that diversification you get and the ability to enjoy returns wherever they might fall around the world, assuming you have a global exposure in your portfolio. Some of the reasons why a country might be developed versus emerging get down to the sophistication and overall development of the economy, of market structures, such as how easy it is to trade in a given marketplace, the legal protections that you might have as an investor in that country.
For example, are you at risk of a government seizing your foreign capital? We've seen that from time to time. Argentina is a good example, where the Argentinean government seized foreign capital and decided they wanted to make it their own. That's a significant risk that you don't necessarily see in developed markets.
Some of those risks you would expect to be compensated for over time with higher expected returns. That tends to be one of the upsides of investing in those markets, but we need to understand that the risks don't just manifest in terms of volatility. There can be other risks involved with some of these emerging markets or even further, if you go down to frontier markets.
Akweli Parker: It stands to reason, I guess, that a lot of what you just said as it applies to international equities also holds true for global fixed income. But I'm sure there must be some differences, too.
Could you speak to some of the special factors that investors should consider when they're thinking about a strategic allocation to international bonds?
Chris Philips: Well, there's the developed-versus-emerging question with international fixed income. There's also the role of international fixed income in U.S. or domestic portfolios.
And when you think about the high-net-worth investor who's in a high tax bracket, the tax advantages of a municipal bond have significant benefits relative to the diversification you might achieve by going global.
If we jump back to the home bias question, there actually can be very rational reasons for a significant home bias for U.S. investors as it pertains to municipal bonds versus other types of fixed income securities.
Akweli Parker: While we're on the topic of international bonds, let's talk about currency risk, which we hear a lot about. Could you explain what that is exactly and maybe some ways to mitigate it?
Chris Philips: Sure. Currency risk is, quite literally, the fluctuation of the dollar versus other currencies. Now, what that means is that, if you have an asset that's denominated in, say, euros, or yen, or pounds sterling, that asset is going to have a volatility to itself. It's going to move in price over time, but it's also going to be impacted by that currency fluctuation. How well or how poorly is the dollar performing versus the pound sterling? That basically gets added on top of the asset performance in that asset's local currency.
Why that's important is that, particularly in fixed income, our research has found that you can really increase the overall risk, the overall volatility, of bonds themselves to the point where they actually look a lot more equity-like in their return patterns over time.
So we took it one step further and said that, yes, we believe you should be diversified into global fixed income, but we only believe that if you can effectively hedge out or mitigate that currency risk. We actually take an approach of hedging it using the derivatives market. We'll actually use one month forward to try to eliminate all that currency exposure, thereby preserving the actual performance of the underlying fixed income instruments.
Akweli Parker: Chris, you recently cowrote a research paper titled, Global fixed income: Considerations for U.S. Investors. In it, you wrote about how the global bond market hasn't always been the friendliest place for the typical investor. Can you talk to us about why that was the case and how things have changed in the past several years?
Chris Philips: Yeah, well, in the '70s, '80s, and even early '90s, the global bond market was dominated by a few large players. It was primarily sovereign issuers, governments issuing fixed income instruments, and the big players in the marketplace would be large banks, insurance companies, large pension funds that are actually looking to hedge out various exposures in their portfolio. What that means is there's not a lot of trading that goes on. And so there wasn't a lot of liquidity in the markets themselves.
An investor might buy a bond and hold it to maturity, thereby not trading it at all over time. What we've seen over the last 15 years is, with the explosion of issuance worldwide, as companies and governments have issued a significantly greater deal of debt instruments, the liquidity has increased dramatically, because now you have more investors able and willing to invest in those bonds. That has spurred the growth in the mutual fund world. So we've seen a lot more mutual funds and ETFs that have launched to invest in these markets as well. They are more inclined to take an active approach in the portfolio. So more trading is involved. That lowers cost, increases liquidity, and, overall, we've seen that really benefit the end investor.
Akweli Parker: Let's circle back to the theme of how political uncertainty feeds volatility, especially in the short term. What are your thoughts, Chris, about short-term versus long-term perspective when it comes to having a global investing outlook?
Chris Philips: Yeah, we saw this last year with the performance in emerging markets. The short term is what everyone focuses on, for better or for worse. So when we're talking with our investing base, what we try to encourage is to take a huge step back and think about what the objective of that portfolio is. The objective of being globally diversified, whether it's in fixed income or equities, is to be more diversified rather than less diversified. Have more exposures rather than fewer exposures. If we are trying to react on a minute-by-minute or day-to-day basis, we're going to end up chasing our own tails. So the importance of focusing on that long-term strategic allocation could not be more critical than any point in time.
Akweli Parker: I think that's really great insight. And that seems like a fitting place to wrap up our conversation about global investing. Thank you, Chris Philips, for this quite enjoyable discussion.
Chris Philips: Thank you very much.
Akweli Parker: And thank you for listening to this installment of the Vanguard Investment Commentary Podcast. Please be sure to check back with us each month for insights on the markets and investing.
- All investments, including a portfolio's current and future holdings, are subject to risk.
- Investments in securities issued by non-U.S. companies are subject to risks including country/regional risk, currency risk, and 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.
- In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
- Past performance is not a guarantee of future returns.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
- 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.
- We recommend that you consult a tax or financial advisor about your individual situation. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
© 2014 The Vanguard Group, Inc. All rights reserved.
An episode from Vanguard's Investment Commentary podcast series
In this podcast, Chris Philips, of Vanguard Investment Strategy Group, discusses global investing. He examines market reactions to world news, differences between developed and emerging markets, and considerations for global equity and fixed income investing.
- All investing is subject to risk, including the possible loss of the money you invest.
- Investments 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.
- Diversification does not ensure a profit or protect against a loss.