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Exposing Yourself

Jonathan Clements  |  April 21, 2018

PUT YOURSELF in their shoes. I’ve been doing that in recent weeks, thinking about how I’d design a portfolio if I lived in, say, Australia, Japan or the United Kingdom. What prompted this navel-gazing? I’m in the middle of revising my 2016 book, How to Think About Moneyfor an international audience.

One conclusion: Here in the U.S., we have it far easier than foreign investors—and a big reason is currency exposure. Roughly speaking, U.S. securities account for half of global stock market value and half of global bond market value. That means we in the U.S. can build globally diversified portfolios—and still end up with relatively modest foreign exchange exposure.

Let’s say you put 50% of your money in Vanguard Group’s Total World Stock Index Fund—which replicates the global stock market—and the other 50% in high-quality U.S. corporate and government bonds. You would own a stock portfolio that holds every significant stock from the U.S. and abroad, weighted by its market value, and yet just a quarter of your overall portfolio would be exposed to currency swings.

Foreign investors don’t have this luxury, because foreign stock markets aren’t just smaller than the U.S., they’re tiny by comparison. Again, consider Vanguard’s Total World Stock Index Fund. As of March 31, U.S. stocks accounted for 51.7% of the fund’s assets. The next biggest country was Japan—at just 8.5%.

Now, imagine Japanese investors followed the above strategy, splitting their money between 50% in a total world stock index fund and 50% in high-quality domestic bonds. Our hypothetical Japanese investors would end up with almost 46% of their portfolio exposed to foreign exchange fluctuations. Given that Japanese investors—like those in the U.S. and elsewhere—will end up spending much of their savings on domestic goods and services, it’s a huge mismatch to have that much of a portfolio exposed to currency swings.

I’ve never been a fan of funds that hedge currency exposure, because of the cost involved and because the added complexity increases the chances that something will go awry (and it gets even worse if a fund is actively managing that exposure, trying to guess whether currencies will weaken or strengthen). But if you’re a non-U.S. investor, buying funds that hedge currency exposure strikes me as the lesser of two evils: It’s better to own a global stock portfolio that hedges currencies than take the risk of keeping much or all of your money in domestic stocks. After all, what if your home stock market has atrocious performance—like the Japanese market, which is still 43% below its year-end 1989 peak?

On top of that, for foreign investors, keeping all their bond market money at home also seems a tad risky. In countries that aren’t as diverse economically as the U.S., there’s a greater risk of bond defaults—and hence a stronger argument for allocating serious sums to foreign bond funds. You would also want those funds to hedge their currency exposure.

That said, you shouldn’t eliminate all foreign exchange exposure from a portfolio, because it can provide added diversification. If the domestic economy weakens, perhaps the currency will fall—and having part of your money in, say, an unhedged foreign stock fund could deliver gains that help offset losses elsewhere in your portfolio.

That brings us to a second advantage enjoyed by U.S. investors: The cost of investing is far lower here and the array of index funds on offer is far broader. Still, I’m impressed at the variety of index funds now available around the world. Indeed, arguably, index funds—both the mutual fund variety and the exchange-traded version—have proven to be one of America’s most successful exports, with firms like BlackRock’s iShares, State Street Global Advisors and Vanguard Group leading the way. Want to see the choices on offer abroad? Check out the index funds available in Australia, Canada, Europe, Japan and the U.K.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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