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By Alex Bryan, CFA | 09-07-2017 01:00 PM

Vanguard: Pairing U.S., Non-U.S. Stocks 'Makes Sense'

Fran Kinniry says holding stocks outside the U.S. helps investors reduce volatility as well as mitigate regret.

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Alex Bryan: For Morningstar, I'm Alex Bryan. We're at the 2017 Morningstar ETF Conference, where I'm joined by Fran Kinniry, who is a senior investment strategist at Vanguard. He's here to talk with me today about the benefits of investing in international stocks. 

Fran, thank you for joining me.

Fran Kinniry: Thanks, Alex.

Bryan: Most large-cap U.S. stocks generate a considerable part of their business outside the U.S., which has led some people to believe that you don't really need to venture outside the U.S. to get global exposure. Is there a case for staying within the U.S. borders, or should investors own some foreign stocks to be properly diversified?

Kinniry: I'd break it into two parts for your question. Indeed, multinational companies can derive a good amount of their revenues outside of the U.S. And so, there's been some who have argued that that gives you enough diversification. All we have to do is go look at the 10-year return time series. You see the U.S. on a 10 year, outperforming non-U.S. by a pretty healthy amount in the 10 year. But then, you see windows like now, where they're trailing one year, one month non-U.S. stocks. So, the fact that revenues can be derived outside of your home market, very true. But, performance deviation is very large. So, putting them together U.S. stocks and non-U.S. stocks, makes a lot of sense.

Bryan: If you're a U.S. investor, can you diversify or reduce your actual portfolio risk by holding stocks outside the U.S.? Would that help you actually reduce your portfolio's volatility? Or, is it more of a way of mitigating regret of being in the wrong market at the wrong time?

Kinniry: Well, it reduces both. So, if you look at a chart of, whether you look at volatility or standard deviation, as you go from 100% U.S. and you add 10, 20, 30, 40% non-U.S., you are reducing your volatility. So, that's the statistical measure of risk. But, the second part of your question, I think it's overlooked too often, which is that regret. The fact that, even if correlations are high, and you get a lot of your revenues from multinationals around the world, the performance streams are very, very different. And so, by putting them together, you end up being closer to the middle, and you avoid that behavioral regret.

Bryan: And is it your view that, correlations today are higher than they once were, back in the 1980s and 1990s. So, despite the increasing globalization of business, you think there's still a potential risk-reduction benefit from being global with your portfolio holdings?

Kinniry: Yeah, absolutely. I mean, I think a lot of people don't understand clearly correlations. So, you could have two assets that correlate at one, but then they could shift. And that's what you see. And so, it's not necessarily correlation, but there's return dispersion of things that still correlate pretty high. And so, putting them together, if you can do so in a low-cost way, makes a lot of sense, because it does shrink volatility, and it does shrink the tracking error to a global portfolio.

Bryan: Speaking of volatility, holding a portfolio of international stocks, a lot of times, on its own, can be more volatile, because you have additional currency risk associated with that. How should investors think about whether or not they should hedge out their foreign currency exposure?

Kinniry: You know, in currency hedging, we think about it in two ways; first, what is the asset class? So, within fixed income, the beta, or the return expectation of fixed income is much lower than stocks. Lets just say the current yield 2, 3%. And the currency volatility is much larger. So, if you don't hedge international bonds, you end up almost with a currency fund, because the volatility dominates the beta. So, we always recommend investors hedge on the bond side. On the equity side, you already have a higher return expectation and high vol. So, the currency part, or the attribution of currency vol is much smaller in stocks.

And so, we don't recommend hedging on the stock side, unless your specific goal is to just minimize vol. So, if that is your objective ... I think we always have to go back to, "What is the objective function of the investor?" If your primary purpose is just to minimize vol, you could then even hedge the equity. But, if you're really looking at return streams, and how do you truncate the return streams and avoid some of that behavioral regret, then you would un-hedge, or just not hedge the equity side.

Bryan: I suppose you can make an argument that, part of the diversification benefit comes from some of that currency exposure, right? 

Kinniry: Yeah. Exactly. I don't recommend anyone have 100% of their assets in their local currency, because we don't know what the future is going to be. And the dollar has gone through periods of strength and weakness. So, if you're already hedging your bonds, we kind of look at it this way; if you're 60-40 stock bond, or even 70-30, and you're hedging your bonds, and you have 40% of your stocks un-hedged, you still have 60, 70, 80% dollar-domiciled assets. And don't you want to have some small portion nondollar in an--it's an uncertain world, going forward, and for those periods where the dollar is underperforming.

Bryan: I think you made a pretty strong case for owning some international stocks. But, how much should investors own? And how should people make that decision?

Kinniry: If you look at most of the research, it's very front-end loaded, the diversification benefits. What I mean, if you start at 100% U.S., and then you add 90-10, so 10 international, the utility of diversification is very steep. And as you start to add 20%, 30%, 40%, it starts to flatten out. So, we are at 40% of equity, so 60% U.S., 40% non. We feel we get the most diversification benefits. It doesn't mean you won't get more by going beyond 40, but there's also incremental costs. Usually expense ratios, bid-ask spreads can be a little larger. So, right now, we stop at 40, we pick up almost all of the benefit, and then don't have that extra cost.

Bryan: Interesting insights. Thank you so much for sharing them with us.

Kinniry: Thank you very much for the time.

Bryan: For Morningstar, I'm Alex Bryan.

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