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By Christine Benz and Jeremy Glaser | 01-26-2017 10:00 AM

Time to Recalibrate Your Foreign Stock Holdings?

With more enthusiasm from experts on foreign-equity returns, Christine Benz says investors may want to check in on--and potentially bump up--their exposure.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the U.S. stock market continuing to rally, many experts think this could be a good time to take a closer look at foreign stocks. I'm here with Christine Benz, she is our director of personal finance, for a take on calibrating your foreign stock exposure in a retirement portfolio.

Christine, thanks for joining me.

Benz: Jeremy, great to be here.

Glaser: You recently wrote an article about expected returns from some market experts, both for U.S. stocks and for foreign equities. And almost to a person they thought foreign equities were going to outperform. Tell us more about that.

Benz: It was interesting. Most had fairly muted return expectations for U.S. stocks, certainly U.S. bonds. But there was a little more enthusiasm for foreign equities. A few firms, Grantham, Mayo, Van Otterloo, as well as Research Affiliates, feel that the prospects for emerging-markets equities are particularly strong. But generally speaking, more positive return expectations for foreign stocks than U.S.

Glaser: That's a turnaround from recent performance where U.S. stocks have outperformed. You think this is a good time then to look at your portfolio and make sure that your allocations are where you expected to be.

Benz: That's right. So, I would emphasize that it's a great time to look at whether you should rebalance your portfolio. For a lot investors who have been just kind of letting their winners ride, chances are that their total equity piece has risen above their target if they've been hands-off, we've had a great rally in stocks. But their foreign as a percentage of their equity allocation has probably declined. So, while you want to reduce your overall equity weighting, don't just give everything a haircut across the board. You may actually want to bump up your foreign equity holdings as a percentage of your equity portfolio.

Glaser: What would be a good starting point or benchmark for deciding how much foreign stocks you should have in your portfolio?

Benz: There are a few different ways to think about it. One starting point is the global market capitalization. So, as of 2016, the U.S. stock market was roughly 55% of the global market cap with the remainder in foreign stocks. Most asset allocation experts don't recommend such high weightings to foreign equities. So, when I look at the allocations of Vanguard's target-date series, for example, they maintain a static 60% U.S., 40% foreign weighting. So, this is as a percentage of the equity portfolio, and they maintain that static allocation across an investor's glide path. Our colleagues at Morningstar Investment Management approach things a little bit differently in that they take down the foreign allocation as an investor gets closer to retirement. So, a younger investor in the lifetime allocation indexes would have roughly 60% U.S. equity, 40% foreign. This is when they're just starting out. By the time they are close to retirement, their foreign equity holdings would be roughly 30% of the equity portfolio.

Glaser: Why would investors in retirement want that lower exposure?

Benz: The thought is that foreign stocks do include some currency-related volatility. So, as you get closer to needing your money, needing to spend your money and presumably you'll do so in dollars, you want less of that foreign currency-related noise buffeting your portfolio around, you want to try to reduce that a little bit.

Glaser: But you could buy a currency-hedged product?

Benz: You could. And certainly, we've seen an explosion of these products over the past few years as investors have seen the dollar soar relative to other foreign currencies. I would say, if you are approaching this decision, just take a strategic approach versus trying to be too tactical about it. So, there are certainly funds that will hedge out their currency exposures. One that is tried and true is Tweedy Browne Global Value where the managers have long said, we think we are good stock-pickers, we're not particularly good currency hedgers, we're not good at guessing the direction of various foreign currencies. So, it has maintained a strategic hedge against foreign currencies. But I think that's the approach that investors should use in their own portfolios as well, probably not try to finally tune their foreign currency exposures based on what they think will happen next.

Glaser: Thinking about securities selection then, is there anything special about selecting a foreign equity fund or ETF versus domestic equity one?

Benz: You probably won't be surprised to hear that I think that the big, boring, broadly diversified products make a lot of sense for most investors. The idea is that you get a lot of diversification. You might get that developed foreign equity exposure along with developing markets equity exposure in a single product. Costs matter for foreign stock funds as well as U.S. stock funds. So, keep an eye on costs. Generally speaking, they will cost a little bit more for some sort of a foreign stock product, but you'd want to try to watch those expenses. And keep it broadly diversified rather than dabbling in, say, some of the region-specific products. While there are certainly some firms that do a very good job with some of those products, Matthews comes to mind for example, I think investors want to be careful about trying to time their exposure to various regions. I'd like the big, broadly diversified products.

Glaser: Christine, thanks for your thoughts on calibrating foreign stock exposure today.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thank for watching.

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