Wed, 14 Nov 2012
With more than 50% of the global market cap being outside the U.S., investors are missing good opportunities if they take a domestic-only approach, says Morningstar's Marta Norton.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How much of your portfolio should you allocate abroad? I'm here with Marta Norton, an investment manager at Morningstar Investment Services, to answer this question.
Marta, thanks for taking the time today.
Marta Norton: My pleasure.
Glaser: So, let’s start kind of big picture. Why does it make sense just generally speaking for investors to think about putting part of their equity and fixed-income exposure abroad versus just having everything in the United States?
Norton: I think there are a few good reasons for that, but at the most basic level, you just have an expanded opportunity set. I mean, at this juncture you have more than 50% of the global market cap actually outside the U.S., so if you were to limit your strategy just to U.S. borders, you’re going to be missing on more than half of the opportunities that are out there. So, that's at the most basic level. You just have more opportunities if you cast a global net, but there is more to it than that. I mean, it's not just quantity; it's quality.
So, there are a number of industries where maybe the powerhouses are located inside the U.S. But there are others where there are big contributors to a particular industry, and they are actually outside the U.S. So, take drug manufacturers. Yes, Pfizer is [in the U.S.] and Johnson & Johnson is [in the U.S.]. But then you have companies like GlaxoSmithKline, a U.K.-domiciled company or you have Roche or you have Novartis, those types of companies. So if you were to limit your universe just to the U.S., you’d be missing on some of these top contributors in certain industries.
And then, I think just lastly, I think there is a matter of diversification. So, any one country has its own economic headwinds or tailwinds, and the U.S. is no exception to that. So, if you are able to expand outside the U.S., maybe you can kind of limit some of the risks, the challenges that the U.S. is facing. Of course, you have to remain cognizant that maybe you are introducing some to your portfolio, as well, but just by spreading it out a little bit more, you have greater diversification.
Glaser: How much of your portfolio, let's say on the equity side, does make sense to have abroad, and has your thinking on that kind of changed during the last couple of years?
Norton: I’d say, we’ve stayed fairly consistent at Morningstar Investment Services in terms of how much we're allocating on a strategic basis to non-U.S. markets. Now that can change tactically speaking, depending on valuations. But generally speaking, for more aggressive portfolios, I’d say, about 30% of the portfolio is actually outside the U.S. on a strategic basis as part of how the portfolio is constructed. Then on the more conservative end of the spectrum, I’d say we have about 6% in non-U.S. [equities], and that's split between developed and emerging markets.
Glaser: So it's an interesting question there between how much of it do you want to be, let's say, in Europe or Japan or into these developed markets versus economies that might be growing a little bit faster? How do you make that decision?
Norton: In terms of any strategic asset allocation, you’re going to be paying attention to returns, to volatilities, and to correlations when you’re setting up. You're split between non-U.S. and U.S. equities, and that kind of thing. And emerging markets are inherently more volatile, and that's been, historically speaking, the case. I think there is a reason to believe that's going to continue to remain the case for the foreseeable future.
So, you want to balance kind of the return potential and the fundamental appeal of some of these countries with the kind of volatility that you are introducing to your portfolio. And a more aggressive portfolio that has more in equities in general, you’re safer, or at least you have more bandwidth, to have more in emerging markets. So, in our aggressive portfolio, I'd say we have about 7% in emerging markets just on a strategic basis, but then when you move to a more conservative end of the spectrum, where investors maybe need more fixed income, more stability, I’d say that emerging-markets stake should still be there, but just at a much smaller level. So we have it at about 1%.
Glaser: How about currency risk? Is this something that you try to hedge out or is this part of the appeal of looking outside the U.S.?
Norton: I think on a strategic kind of secular basis, I think currency is important. I think diversification should never be limited to just security type; it can also be limited or expanded to currency. So, we like currency exposure, especially because we have a secular view that the dollar has its own headwinds over time. So you might want some other currency in the portfolio, but that’s not to say that you shouldn’t make tactical adjustments.
When we put a mutual fund manager on our portfolio, we like to see that the manager can hedge currency depending on the situation at hand, depending on the kind of exposures he already has in the portfolio. And we allow him to do that on a tactical basis. We don't do it, but we don't mind it if he does.
Glaser: Now, on the fixed-income side a lot of investors last few years have increasingly been looking abroad for their fixed-income needs given how low yields are in the U.S. Is this something that actually makes sense, in a strategic sense, or is it just more of a tactical thing people are doing now to pick up that extra income?
Norton: I think with non-U.S. bonds, it's a very important part of anyone’s portfolio on a strategic basis. The argument is very similar on the fixed-income side as it is on the equity side--you want an expanded investment universe. And on the fixed-income side that means sovereigns and corporates, and then you also have the diversification that comes and those kinds of factors. So, I think that's important on a strategic basis. I can certainly understand why investors find non-U.S. bonds particularly attractive now. When you look at Treasuries and Treasury Inflation-Protected Securities, and you see really paltry yields in those areas, I think it makes sense to start looking where are you finding an attractive healthy yield elsewhere. And I think non-U.S. bonds in many cases can offer that. I mean, you have to be careful; every area has its own issues.
But over the past few years, we have been particularly entranced with emerging-markets bonds. We think a lot of fundamentals there are fairly attractive. We think the yields are fairly attractive in particular when you compare them with what we have [in the U.S.]. So, I think on a tactical basis even we've been making that call, but strategically speaking, I think non-U.S. bonds have a place in people’s portfolios.
Glaser: Marta, thanks so much for your thoughts today.
Norton: Absolutely. Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser.