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Investing Specialists

How Much Foreign Stock and Bond Exposure Do You Need?

One-size-fits-all answers are few and far between, but we provide a few guideposts.

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Note: This article is part of Morningstar's May 2015 International Investing Week special report.

How much should you invest overseas? 

It's one of the central questions confronting investors putting together their portfolios, yet there's surely no consensus. Some experts argue for highly globalized portfolios, with allocations to foreign and U.S. stocks and bonds mirroring their market values. 

But other experts believe that due to the extra costs and volatility that can accompany foreign stocks and bonds--and especially the foreign-currency swings that can occur when those market gains or losses are translated into U.S. dollars--less is more when it comes to foreign exposure. 

A related question is whether--and how--a portfolio's allocations to foreign and U.S. stocks and bonds should change over time. Some asset-allocation frameworks directly reduce the percentage of foreign stock and bond exposure in a portfolio as the investor gets closer to retirement, while others do so only indirectly--that is, the portfolio's ratio of foreign to U.S. stocks remains static, but the total equity allocation declines over time. 

Unfortunately, the "right" allocations to foreign stocks and bonds will be evident only in hindsight. But let's take a closer look at various ways to approach these questions. For the purpose of this article, I'll assume that investors are pursuing a strategic approach to asset allocation (that is, buy, hold, and rebalance) versus a tactical strategy driven by valuations or other factors. 

Stock Allocations: Fully Global, U.S.-Centric, or Somewhere In-Between?
The issue of how much investors should stake in foreign stocks has been a contentious one for years. 

In the "less foreign is more" camp are folks like Jack Bogle, who believe that because many U.S. blue chips are increasingly global in their reach, investors in them get plenty of exposure to foreign markets indirectly, while avoiding the extra costs and volatility associated with foreign stocks (foreign-currency swings in particular). Even investors who see that viewpoint as outmoded must acknowledge that where a company is headquartered--which currently determines whether a stock is classified as foreign or domestic--is an imprecise and, in many cases, downright misleading guide to a company's international operations. As discussed here, iconic "U.S." companies like  McDonald's (MCD) and  Coca-Cola (KO) derive huge shares of their revenues from their overseas operations. 

At the other extreme are the "global market-cap agnostics"--those who say you should simply buy a basket of U.S. and foreign equities weighted according to their market values and call it a day. The U.S./foreign allocations of global-market indexes such as the FTSE Global All Cap Index have hovered right around 50/50 for the past several years. Right now, that index's allocation is 51% U.S./49% non-U.S. 

Meanwhile, most asset-allocation experts recommend a middle ground. As discussed here, investors don't need to steer half of their portfolios to foreign stocks--their approximate weighting in the global market capitalization today--to obtain most of their diversification benefits. Target-date mutual funds showcase many investment shops' takes on this matter. Within their target-date series, for example, both T. Rowe Price and Vanguard steer roughly two thirds of their equity allocations to U.S. stocks and the remainder to foreign. 

Morningstar's Lifetime Allocation Indexes allocate anywhere from 21% of equity assets to foreign stocks (for the conservative income index) to 40% (for the aggressive 2060 index). The rationale behind those varying exposures gets back to volatility. As investors get closer to needing their money in retirement, they shouldn't just segue to a more conservative stock/bond mix; their intra-asset-class exposures should also change to emphasize more conservative investment types. Because foreign stocks typically entail some currency risk as gains or losses are translated from foreign currencies to dollars, Morningstar research has concluded that foreign weightings should decline accordingly. (This paper does a deeper dive into the topic; I summarized it in this article.) That said, retired or near-retirement investors who are employing a foreign-stock fund that hedges its currency exposure and tends to emphasize developed-markets equities--such as  Tweedy, Browne Global Value (TBGVX)--might reasonably steer a larger portion of their portfolios to foreign stocks. 

Bonds: It's Complicated
How much of a portfolio to steer to foreign bonds is a more complicated question, in large part because of the huge variety of tacks one might employ. For example, Morningstar's world-bond category encompasses funds that are fully exposed to foreign-currency fluctuations, as well as those that hedge their currency exposures; funds also vary in their exposures to developed/developing markets and government- and corporate-issued bonds. Because types of foreign-debt exposure vary so widely, one-size-fits-all recommendations are tricky. An investor could reasonably steer a larger share of her fixed-income portfolio to a hedged international-bond fund that emphasizes sovereign bonds rather than an unhedged product that emphasizes corporate and/or local-currency-denominated debt. The former product type would tend to have much lower volatility and be much more "bondlike," whereas the latter product would entail volatility more in line with stocks. 

However, it's safe to say that few asset-allocation experts are in favor of mirroring the global markets' allocation to U.S. and foreign bonds. Even though more than 50% of the world's fixed-income investments exist outside the United States, and foreign bonds represented a third of the globe's market cap at the end of 2012, investing in foreign bonds has the potential to add cost and volatility to a U.S. investor's portfolio. 

The volatility issue can be addressed--at least in large part--by hedging out the currency risk of the foreign bonds; that helps ensure that investors partake of foreign bonds' yields and any price changes, but not the currency-related impact when those returns are translated into dollars. However, hedging strategies entail costs, and in a low-returning asset class like bonds, those costs can take a big bite out of returns. That's a key reason that Morningstar's Lifetime Allocation Indexes, as well as target-date investment providers, have generally not mirrored the foreign/U.S. bond weightings of the global market capitalization. 

Vanguard recently added foreign bonds to its target-date series, but in a weighting of 20% of fixed-income investments, as outlined here. That fixed-income exposure is entirely hedged; the goal is to deliver some diversification by providing exposure to varying interest-rate environments while also keeping the risk profile in line with high-quality U.S. bonds. 

Meanwhile, T. Rowe Price's Retirement funds maintain foreign-bond weightings in a similar ballpark, but their complexion is different. In particular, the target-date funds invest in  T. Rowe Price International Bond (RPIBX)--an unhedged product that focuses on developed-markets debt--as well as  T. Rowe Price Emerging Markets Bond (PREMX). The actively managed core bond fund,  T. Rowe Price New Income (PRCIX) also has the latitude to invest a portion of the portfolio in non-U.S. bonds. 

In keeping with research on intra-asset-class exposures getting more conservative as investors get closer to retirement, Morningstar's Lifetime Allocation Indexes start out with 20% of their fixed-income exposures in foreign bonds for very young investors (aggressive investors retiring in the year 2060), but then gradually scale back the foreign allocation of the bond portfolio as retirement approaches. For a conservative investor in retirement, for example, the indexes include just a 5% stake in foreign bonds. (Note that I'm calculating the foreign-bond percentage by dividing foreign-bond exposure by the total bond exposure, including TIPS.)

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Christine Benz has a position in the following securities mentioned above: TBGVX. Find out about Morningstar’s editorial policies.