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By Dan Culloton | 09-27-2010 01:05 PM

Sauter on the Sweet Spot for International Allocation

The Vanguard CIO discusses the firm's decision to increase the international weighting in its target-date funds to 30% from 20%.

Dan Culloton: Speaking of asset allocation, Vanguard made an announcement today regarding changes to your target-date retirement lineup, which increases the weighting of the international exposure from 20% of equities to 30% of equities. What does this say about what Vanguard thinks is the ideal asset allocation--ideal domestic and international allocation for a portfolio?

Gus Sauter: Well, we continue to do research on our target-date funds as well as other funds, and we did feel that we could enhance diversification a bit by increasing the international weight. I should say that, we do not expect greater returns from an international investment. We think the advantage of investing internationally is to gain broader diversification. And I'll say that with the caveat that we know correlations have increased between domestic equities and international equities. At the same time we know that during times of crisis that the correlations tend to go to one.

Nevertheless, if you get some advantage from diversification, some is better than none. So, we look for kind of the sweet spot on the efficient frontier, if you will, to try to figure out what an appropriate allocation to international equities should be. What we found was that it's really probably more centered around 30% than 20%. So, we're increasing that allocation. Again, not because of expected increase in returns, but because we think we'll get a little bit lower volatility in the overall portfolio.

Culloton: If correlations are closer between domestic and international stocks, and the expected return isn't likely to be – in your view -- isn't likely to be really very different, where is the diversification coming from?

Sauter: Well, I think, you look at different countries, and different countries do have different fortunes. If we look at Australia for one; Australia has actually performed quite well over the last decade while the rest of the world in the developed space has been flat. So, you're getting the diversification because different economies are growing differently, and to some extent different countries have different industry weightings than you would have in the U.S.

So, Australia has been growing quite rapidly because of its resource-based economy and so by including Australia in a portfolio, you're getting a bit more of an exposure to resources, which has been beneficial over the last decade. No telling that it will in the future. We don't know exactly how all the dynamics will play out, but it stands to reason from theory and from what we've experienced that including additional country exposure does help a diversified portfolio.

Culloton: The other side of the coin is that you could argue that if you really want a globally weighted portfolio, you should have a lot more in international. Why not have more in international?

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