International Allocation

Giant Disclaimer

While I pretend to vaguely understand some aspects of frugality and the US tax code, I don’t pretend to be an investing guru. In fact, I’m pretty ignorant on the topic. So please take this post with a gain of salt.

 

Introduction

I’ve given some thought recently on the role of international holdings in my portfolio.

To date, I’ve held international funds in my portfolio for a few reasons:

• Diversification:
  • Owning more firms can’t hurt, right?
    • Vanguard’s total international index fund holds 7,420 stocks (link).
  • Having exposures to more currencies can’t hurt, right?
    • If the dollar weakens relative to other currencies, then owning foreign businesses could help offset the weakening of the dollar. This would help to increase the returns of a US investor in the event of a weakening dollar.
      • This, of course, comes at a cost. If the dollar strengthens relative to other currencies, then holding foreign firms would reduce one’s investing returns.
  • If stock returns across countries are weekly correlated, then holding a mix of US + international stocks would serve to lower the volatility of ones portfolio.
• Everyone else seems to be doing it:
  • (Admittedly not the greatest of excuses….)
  • For example., the equity component of Vanguard target date funds is split 60% domestic / 40% international.
    • It seems arrogant to think I’m smarter than Vanguard.
• Today, international valuations are relatively attractive:
  • International funds have a P/E ratio of 19.4 (link).
    • The corresponding E/P ratio is 5.2%.
  • Domestic funds have a P/E ratio of 28.1 (link).
    • The corresponding E/P ratio is 3.6%.
  • However, there are rational reasons for these ratios to vary across countries. It’s sensible for the P/E ratios in more stable countries to be higher than the P/E ratios in less stable countries.
• Corporate tax diversification:
  • It seems to me that US stock returns are heavily dependent on corporate tax policy.
    • If US corporate taxes are low (as they are now), this is good for investors in US firms as lower taxes result in higher net income. However, if future US corporate tax policy changes, this could adversely affect all firms in a domestic equity portfolio. This common factor to a single potential shock has me a little unsettled.
      • By holding international stocks, an investor can mitigate this risk.
    • I haven’t really heard of anyone else using the above as justification for holding international stocks, but it seems sensible to me. The US tax code one of the primary things all US firms have in common.

However, I’ve recently questioned the wisdom of holding international stocks:

• Bogle & Buffett, both of whom I admire a lot, aren’t terribly keen on foreign stocks.
  • Their basic argument is that many US firms are “multinationals”, meaning that they have significant revenues abroad. Consequently, you already own plenty of international diversification when you buy an S&P 500 or total domestic stock index fund.
  • Further, they also seem skeptical of shareholder protection & government stability in other nations.
    • Other nations, for example, might have less stable governments in which unscrupulous leaders baselessly deny election results and incite violent coups. This could never happen in the US…..
  • Aswath Damodaran feels similarly (link).
• International funds have underperformed domestic funds by a wide margin.
  • Over the past 10Y, here are the returns:
    • Domestic: 13.45% (link)
    • International: 5.00% (link)
  • Since 1996 (24.75Y), the (geometric) average returns are as follows (per my calcs):
    • Domestic: 9.2%
    • International: 5.3%
  • Since past performance is the best indicator of future performance, we should expect domestic equities to outperform international equities by 3.9%/year forever. Common sense tells us that we should sell low (international) and buy high (domestic).
    • That was blatant sarcasm. Admittedly, it was not the best of deliveries.

 

Relevant Screenshots

Here’s how Vanguard’s 2060 target retirement fund is allocated. There is a 60%/40% domestic/international split. International equity = (36.3%/(54%+36.3%)).

 

Here’s what you get when you buy Vanguard’s total international stock market index.

 

 

Here’s how the Vanguard total world fund is market-cap weighted across countries. The above implies that a portfolio of 56.7% domestic and 43.3% international would be free of any “home (country) bias.”

 

In-Class Activity

This past week in my intro to finance course, we discussed risk vs returns. It’s a fun topic to teach because we talk about:

• The benefits of diversification
• The efficient frontier
• Sharpe ratio (= excess return / volatility).
  • Excess return is defined as the return in excess of the risk free rate.

During an in-class activity, I had my students play around with some data. Specifically, we played around with monthly returns for Vanguard’s total domestic & international funds from June 1996 to Feb 2021. I hadn’t personally played around with the data before, and I found the exercise to be pretty fascinating.

You can download my sheet here if you want to play around with it (link).

 

Plotting Monthly International (y-axis) vs Domestic (x-axis) Returns

For most of the analysis, I did it in three parts:

• Full sample (June 1996 – Feb 2021)
• First half (June 1996 – Sept 2008)
• Second half (Oct 2008 – Feb 2021).

What really stood out to me is the incredibly strong correlation between domestic and international stocks. I understood this to be true before playing around with the data, but I was pretty surprised by the analysis.

The correlation between domestic and international returns seems to be increasing over time, manifested by higher R^2 (78%) in the second half of the sample than the first (71%). This tightening of correlations makes a lot of sense. The world is becoming more interconnected. As multinationals increase their reach, it makes sense for domestic and international equities to be so highly correlated. This is the main Buffet/Bogle argument. They claim you get sufficient international diversification by holding only US firms.

Whole sample. Y axis is international returns. X axis is domestic returns.

Most recent half of sample. Y axis is international returns. X axis is domestic returns.

Older half of sample. Y axis is international returns. X axis is domestic returns.

 

 

Plotting the “Efficient Frontier”

We talked in class about the “efficient frontier.” I thought it would be fun to map out the risk vs return tradeoff for an investor who only invests in two assets: a total international and total domestic equity index fund. Here’s the analysis:

Here’s what the “efficient frontier” looks like for those two asset classes over the whole sample period. The bottom point is 100% international equities. Each point between these extremes is 10% more/less international equities. From June 1996-Feb 2021, holding between 20%-30% in international equity fund would have minimized one’s portfolio volatility over this time period. However, the objective of an investor is obviously not to minimize their volatility, but rather to maximize their excess returns / volatility (the Sharpe Ratio). When we zoom out the above chart, the next chart is produced. I’m simply changing the range of the X axis.

 

In this zoomed out chart, we clearly see that 20%-30% international allocations don’t maximize the Sharpe Ratio over the past 12.5 years. The 100% domestic fund obviously does that over this sample period. It’s the highest point on that chart. Return differential aside, what’s particularly striking to me in this chart is the fact that holding international stocks in one’s portfolio didn’t significantly reduce the portfolio’s volatility. This makes sense given the extremely high correlations we saw in the scatterplots above.

 

Here’s what the chart looks like for the most recent half of the sample. The bottom point is 100% international equities. Each point between these extremes is 10% more/less international equities.

 

Here’s what the chart looks like for the earlier half of the sample. The top point is 100% domestic equities. The bottom point is 100% international equities. Each point between these extremes is 10% more/less international equities.

 

 

Wrapping it up

While interesting, these backwards-looking efficient frontiers and scatterplots are not particularly informative to us in how to allocate going forward. Rather, they tell us how we should have optimally invested in the past. Armed with these plots and a time machine, I certainly would have made some different investing decisions in the past.

Nonetheless, I think the analysis is thought provoking. If nothing else, I hope to have convinced you that the diversification benefit (in terms of volatility reduction) from holding international stocks is small and getting smaller in an increasingly interconnected world.

Despite this, I still think you can rationally justify holding anywhere between 0% – 43.3% of international equity holdings going forward. If only we had a crystal ball to see which asset classes would outperform going forward….

 

Reader poll

What is your international / domestic split? Why?