Whether it’s manufacturing, technology, trade, or retail distribution, globalization is the new normal. It’s the same with investing.
Carefully considered global exposure is an important part of any well diversified portfolio. We talked to Mr. Zilbering, one of the authors of a research paper entitled Vanguard’s framework for constructing globally diversified portfolios.
Here’s what Mr. Zilbering had to say about some of the important decisions you need to make when constructing globally diversified portfolios for your clients.
Vanguard: Tell us about the importance of a top-down hierarchy to portfolio construction.
Top-down hierarchy is exactly that. It’s about focusing on the most important aspect of portfolio construction, which is broad asset allocation and diversification. We know that picking a suitable asset allocation is the most important decision in building a portfolio
Studies over the years have shown that asset allocation is responsible for most of the returns, as well as the variability of the returns of a diversified portfolio over time. Our own Vanguard studies have also shown that over 90% of a portfolio’s return variability can be explained by its strategic asset allocation.*
The other 10%, including active investment decisions and market timing tend to have relatively little impact on return variability. Unfortunately, we find that many investors focus on that other 10%. They construct their portfolio bottom-up. They’re basically fund collectors in a sense. That approach can result in a portfolio that fails to meet their long-term investment objective.
Vanguard: Talk a bit about fund collecting.
Mr. Zilbering: Essentially, it’s looking at a fund that may have performed well over the past calendar year and thinking, “You know, I don’t want to miss out on this good-performing fund.” Or it could be a client deciding to invest in a particular regional fund because he or she believes that region’s going to do well next year. Perhaps it’s picking a fund based on its star rating, which might be the most common mistake advisors see investors make.
Vanguard: For advisors who are looking to add an international component to their clients’ portfolios, what’s a good starting point, and what types of investments should they be looking at?
A good starting point for client portfolios that don’t already have allocations outside of the home country is to look at the global market cap. For example, an advisor can look at a FTSE global all cap index and see that the U.S. represents roughly 55% of the equity market, and perhaps the portfolio starting point is around 55% to match that market cap.
You can perform the same exercise on the fixed income side. The U.S. represents about 45% of the global market cap, so a portfolio where your U.S. fixed income holdings are roughly 45% is probably a good starting point. We believe a reasonable default option to do that and to invest in a global market cap index fund. It’s a low-cost way to get broadly diversified exposure to those global asset classes.
Of course, there are certain restrictions and some investors may have home bias or a preference for investing in their home country because there’s a comfort level there.
Vanguard: When you say “home bias,” is that exclusive to U.S. investors, or do investors generally have a natural home bias?
Mr. Zilbering: It’s definitely not exclusive to U.S. investors. In fact, the U.S. may have the least amount of home bias. For example, the U.S. represents about 55% of global market cap. U.S. investors hold about 79% of their equity portfolios in U.S. stocks, which is roughly a 50% overweight.
However, when we look at countries like Canada, for example, that country market cap is only 3%. But if you look at the exposures to Canadian equities there, you see that investors hold about 54%. That represents a substantial overweight to market cap, a much heavier allocation to their home country. We see similar trends in other regions around the world.
Equity market home bias by country
Notes: Data are in U.S. dollars, as December 31, 2015 (the latest available from the International Monetary Fund, or IMF). Domestic investment is calculated by subtracting investment (as reported by the IMF) in a given country from its market capitalization in the MSCI All Country World Index. Given that the IMF data are voluntary, there may be some discrepancies between the market values in the survey and the index.
Sources: Vanguard calculations, based on data from the IMF’s 2015 Coordinated Portfolio Investment Survey, Bloomberg, Thomson Reuters Datastream, and FactSet.
Article by Yan Zilbering of Vanguard, Advisor Perspective