International Asset Allocation - Importance?

[veritasophia]

How important is it for your international allocation to be divided equally among Europe, Pacific and emerging? For instance, if you were investing with VG funds, instead of going with the Total Int'l Index (58% Euro, 28% Pacific, 14% Emerging); how important is it to divide equally among Euro, Pacific, and Emerging?

 

[Cool Dood]

Not at all important.

 

[wabmester]

That's sort of a philosophical question.

Vanguard probably attempts to weight the allocation according to world-wide market cap weighting. That sort of weighting makes sense to people who believe that the markets allocate capital efficiently.

Some people believe you should overweight various asset classes for various mysterious reasons.

And others believe that you should equally weight various asset classes for neatness, I guess.

(Can you guess which camp I'm in?)

 

[justin]

Some think emerging markets is more risky but will have a higher growth rate (= higher rate of return) in the future. That would suggest overweighting emerging markets to increase your overall international rate of return.

One advantage of owning the three international "regional" funds instead of total int'l index is to get the rebalancing alpha. Assuming the returns of the three regional funds are sufficiently uncorrelated, there's a good chance you can increase your overall international return by rebalancing to a target allocation of the three components (ie - Europe - 55%, Pac - 30%, EM - 15%). Rebalancing will force you to sell the outperforming (overvalued) asset(s) and buy the underperforming (undervalued) asset(s).

A third reason would be to get the foreign tax credit. If you own the 3 regional funds in a taxable account, you can take as a credit on your US tax return any foreign tax paid by your fund on your behalf. My understanding is the consolidated total international fund at Vanguard does not allow you to take this tax credit. If memory serves, this amounts to approximately 0.25-0.5% of the amount invested per year.

Then there's the issue of portfolio size. You'll be paying $10 per fund with less than $10,000 in it. If you have 15% allocated to emerging mkts, you'd have to have a total of $66,667 in the three regional international funds to completely avoid the $10 fees. In contrast, the total international only requires $10,000 to avoid the $10 fee. Each fund has a $3000 minimum purchase as well. That may make your Em. mkts part of your portfolio overweight at first.

A benefit to owning the total international is you don't have to pay the 0.5% purchase and sales charge for the Emerging markets fund. However, if you are a long term investor, I think the tax savings for holding the 3 regional funds separately will offset this initial purchase fee, assuming you are in a taxable account.

Personally, I've opted to own the three regional funds separately in taxable accounts and intend to rebalance to my target allocations.

Overall, it may be splitting hairs a little to favor one approach over the other. The more complex approach has more benefits in my opinion, but it sure is easy to buy a single fund and let the market do it's job.

 

[Cool Dood]

I don't see any reason to bother with Western European stocks...

 

[justin]

I don't see any reason to bother with Western European stocks...

This seems to contradict your earlier post where you said it's "not at all important" to equally weight the 3 regional funds. Equally weighting the 3 regional funds will, in effect, underweight the European allocation relative to what it would be in the total international fund. 33% in equal weighting vs. 58% in market cap-based total international fund.

Although I tend to agree that the Europe fund won't do quite as well as the pacific fund or the em. mkts. fund in the next decade or two. That's one of the reasons why I'm equally weighting the three regional funds.

 

[veritasophia]

Justin,

Thanks for the reply. I was considering the 3 funds over the total because of potentially higher returns (Emerging fund) and rebalancing. I didn't think about the taxes. Are you sure that foreign taxes can not be deducted with the Total fund?

What gets me is the .5% purchase and sales fee for ermerging markets, its hard for me to justify paying that. Then their is the $10/fund under $10,000. I may take me a while to reach $10,000 in each fund so I guess I'll just stick to the Total Int'l fund.

Vanguard probably attempts to weight the allocation according to world-wide market cap weighting. That sort of weighting makes sense to people who believe that the markets allocate capital efficiently.

Hey Wab, could you clarify market weighting please? Is it just putting more emphasis on the world markets that have a greater number of major companies?

 

[Cool Dood]

I'm not sure if you're saying something with particular reference to that company's offerings, in which case I don't really know the details under discussion. What I meant with my first post is that it doesn't really matter what percentage you are in specific foreign markets: there's not some magical ratio among European and Asian and whatever other markets. It's good to diversify, but you might as well pick stocks or funds in whatever markets you find appealing, and not bother about how some other people do it.

And, to me anyway, there's no appeal in W. European markets.

 

[wabmester]

the Europe fund won't do quite as well as the pacific fund or the em. mkts. fund in the next decade or two. 

Where do I get one of those crystal balls?

The best argument against Europe is demographics.   Of course, Japan has even worse demographic trends, so it's hard to imagine why you think Pacific will outperform over the next 10-20 years.

Hey Wab, could you clarify market weighting please?  Is it just putting more emphasis on the world markets that have a greater number of major companies?

If you believe that capital markets are efficient, then cap weighting automatically gives you the "correct" allocation.

But a lot of people believe, for example, that small caps will outperform large caps over the long term.    They are betting against efficient markets.   If the markets are efficient, then the small caps deserve their small capitalization and you shouldn't allocate any more to them.

The same can be said about country-based allocation. The markets have figured out the amount of capital that each country deserves to have invested in them, so you can use that as a guide for your own allocation.

 

[justin]

Cool Dood,

Gotcha. I thought you were responding and referencing the particular Vanguard funds Veritasophia mentioned.



Veritasophia,

I'm almost a year into my new portfolio allocation strategy. My take on the 3 regional int'l funds vs. the total funds was to go with the three regional funds. In order to reduce fees, I decided to start with one fund (Pacific) and starting dollar cost averaging into it until I had acquired $10,000 of the fund. Then I moved on to the next fund, in my case emerging markets, and I'm currently in the process of acquiring a $10,000 position in this fund. When I reach that goal, I'm going to start with the European or total market fund and acquire a $10,000 position in it. For the first few years I'll be unbalanced, but after I get the $10,000 into each fund, I can balance each year without paying the $10 fee.

In your situation, there's always the option to add one of the regional funds after you have a position in the total market fund to overweight one of the regions.

 

[justin]

Where do I get one of those crystal balls?

The best argument against Europe is demographics. Of course, Japan has even worse demographic trends, so it's hard to imagine why you think Pacific will outperform over the next 10-20 years.

If you believe that capital markets are efficient, then cap weighting automatically gives you the "correct" allocation.

In general, I think the governments represented in the European fund are more anti-business than countries represented in the Pacific fund. As a result, I think companies will have slightly higher earnings in the Pacific fund over the long term.

I also think Japan has more potential upside than Europe right now. When (if) the Japanese economy heats back up, their market will reflect it. When (if) domestic investors in Japan start flocking back to their stock market for investments, it will go up. It's been in the crapper for a long time. I originally started buying the Pacific fund last year around this time because of it's relatively poor performance compared to the other regional funds (a value play).

And remember, I'm making a small bet - 33% weighting for Europe vs. 58% based on Market cap. I don't have a crystal ball, just a hunch. Plus I'll (theoretically) get a small rebalancing bonus.

My major bet in the international sector is to overweight emerging markets. I think it will be more volatile over the next couple decades, but should offer higher long-term returns to compensate for the risk. And developing countries are able to grow at a faster rate than developed countries. Again, no crystal ball, just a hunch.

 

[wabmester]

In general, I think the governments represented in the European fund are more anti-business than countries represented in the Pacific fund.  As a result, I think companies will have slightly higher earnings in the Pacific fund over the long term.

You may be right, but don't you think that such factors have already been considered and are reflected in their market caps?

 

[rs0460a]

Some think emerging markets is more risky but will have a higher growth rate (= higher rate of return) in the future. 

Yes, that is part of the discussion in "Four Pillars".

It's always better to have a "little bit of something" in your portfolio.  How it is broken down could present a never ending discussion on investment ratios, government direction, etc. etc. etc.

Invest a bit.  If you make out well - good!  If not, you haven't made a "bad decision" with a lot of $$$.

What's most important is simly "DO SOMETHING!"

- Ron 

 

[justin]

You may be right, but don't you think that such factors have already been considered and are reflected in their market caps?

I think the market caps of each individual region reflects the factors particular to that region.

However, I don't think the relative market weightings between the different regions mean a whole lot. The economy of the European Union had a GDP of approx. $12.2 trillion in 2005, whereas Japan's GDP was only $3.9 trillion. The main reason is that the EU is approximately 3 times more populous than Japan. As a result, the EU's combined market cap is much larger than Japan's market cap.

As investors, we can let the international market cap weightings determine where we invest, or we can make certain bets on certain areas. If you step back for a minute, most of us also go against international market cap weightings when we allocate a lower percentage to international holdings than what would be suggested by the international market cap weightings (including the US market). In other words, we overweight the US market and underweight the rest of the international market.

On a different note, I thought of another advantage to owning the three regional funds separately. Admiral Class shares are available for the Europe and Pacific fund (to get you lower expense ratios) whereas the Total International fund does not have an admiral class of shares available. Could save you 10 basis points or so if you've got a few hundred thousand to invest...

 

[rs0460a]

On a different note, I thought of another advantage to owning the three regional funds separately.  Admiral Class shares are available for the Europe and Pacific fund (to get you lower expense ratios) whereas the Total International fund does not have an admiral class of shares available.  Could save you 10 basis points or so if you've got a few hundred thousand to invest...   

Just a "real life experience"

I was Admiral class on VGHAX (evolution from VGHCX after holding it for many years).  End of '05, I "redistributed" (meaning split) my allocation from VGHAX to VGHCX, VGHEX, VIMSX, and VGSTX.  You can run the YTD '06 numbers yourself, but just to show that "Admiral class" (in itself) dosen't account for much, in the scheme of things... 

For a "true believer", Admiral is certaily better than the "base fund", but I still go back to the idea of "spread your $$$ around" (many "baskets")  :

- Ron

 

[wabmester]

In other words, we overweight the US market and underweight the rest of the international market. 

Maybe you do, but I let the global market cap weighting guide my allocation strategy, so I shoot for about 50% international.

You don't have to be a slave to market cap weighting, and I make side bets too, but basically I see market cap weighting as the best approximation for "smart" allocation.    Every other approach I've seen is indistinguishable from voodoo.

Here's an oversimplified example of why market cap weighting makes sense.   Let's say you have $1M to invest, and you're given two possible investments:

1) Joe's Liquor Store (market cap $200K)
2) GE (market cap $350B)

Nobody in their right mind would give equal weighting (invest $500K each) to Joe's and GE.     If Joe's was a public company, then you can use their market caps as a reflection of how the market has voted to allocate capital.    That's what I use as a rule of thumb for my allocations.    (And I have a bunch of side bets as well, because I think I'm smarter than the market.  )

 

[veritasophia]

My major bet in the international sector is to overweight emerging markets. I think it will be more volatile over the next couple decades, but should offer higher long-term returns to compensate for the risk. And developing countries are able to grow at a faster rate than developed countries. Again, no crystal ball, just a hunch.

Justin,

This is what I had in mind as well, but do you think the .5% purchase and redemption fee is worth the potential long-term returns?

 

[justin]

Wab, I happen to shoot for 50% international as well, and a big reason is the international market caps. I don't want to bet too strongly against "the market".

But I rarely see the pundits (the good ones and the bad ones) recommending a 50% international allocation.

For your example with GE and Joe, investing based solely on market cap would have you investing $999,999.43 in GE and a measly $0.57 in Joe's liquor store. All I'm suggesting is that if one thinks one is smarter than the market, it's ok to buy $2.00 of Joe's Liquor store and $999,998 in GE.

You might beat the market slightly or underperform the market slightly, but you'll have returns pretty close to what the market as a whole produces.

Wab, it sounds like you disagree with the notion that small-cap/value/emerging markets tilts will enhance portfolio returns.

 

[wabmester]

Wab, it sounds like you disagree with the notion that small-cap/value/emerging markets tilts will enhance portfolio returns. 

Bingo.   Fundamentally, I believe that you and I have access to the same information available to every other investor.   Any historic premium paid by small/value is very well publicized by now, which means it will go away in the future.   In fact, I think the *extreme* outperformance of small/value of the last few years is due solely to the recent popularity of MPT, so it may go away in a big way relatively soon.

 

[Texas Proud]

Justin,

Thanks for the reply.  I was considering the 3 funds over the total because of potentially higher returns (Emerging fund) and rebalancing.  I didn't think about the taxes.  Are you sure that foreign taxes can not be deducted with the Total fund?

What gets me is the .5% purchase and sales fee for ermerging markets, its hard for me to justify paying that.  Then their is the $10/fund under $10,000.  I may take me a while to reach $10,000 in each fund so I guess I'll just stick to the Total Int'l fund.

Hey Wab, could you clarify market weighting please?  Is it just putting more emphasis on the world markets that have a greater number of major companies?

I do not know if this has been answered.... but I have the total international fund and you do not get a foreign tax credit... but, from what Vanguard told me you do not get the gross amount either...

 

[justin]

This is what I had in mind as well, but do you think the .5% purchase and redemption fee is worth the potential long-term returns?

Yes, it's worth it in my opinion. You are talking about $15 on a $3000 purchase. Even if you only hold it for 1 year, the total expense for that year would be about what the next cheapest emerging markets fund would be.

I wouldn't recommend allocating all of your international exposure to emerging markets. The total market fund or a combination of the three regional funds should be the base, and then overweight emerging markets (for example) if you think that is where the long-term prospects are best.

I am growing a little concerned that the emerging markets fund is "overvalued" right now due to the recent run-up. But that concern was there before it's latest 40% run-up.

 

[justin]

I do not know if this has been answered.... but I have the total international fund and you do not get a foreign tax credit... but, from what Vanguard told me you do not get the gross amount either...

What is the "gross amount" you are referring to?

 

[Texas Proud]

Bingo.   Fundamentally, I believe that you and I have access to the same information available to every other investor.   Any historic premium paid by small/value is very well publicized by now, which means it will go away in the future.   In fact, I think the *extreme* outperformance of small/value of the last few years is due solely to the recent popularity of MPT, so it may go away in a big way relatively soon.

I will disagree with you on this... but since it is an opinion it will not change your mind...

Smaller cap stocks are more risky, hence they have a risk premium... they should outperform less risky stocks all the time over a reasonable time frame.

using your example on bonds... all people have the same information on bonds, so it does not matter if it is a AAA vs a B, the return will go away over time... well of course this is absurd...

 

[Texas Proud]

What is the "gross amount" you are referring to?

The tax is paid out of the fund proceeds. Your taxable amount is grossed up by this tax (maybe someone can check on this)..

The total is getting a certain amount of cash from the three other funds. They distribute the cash which is net of the taxes. Maybe the tax credit is better than the net cash, but probably not something to worry to much about.

 

[justin]

My understanding is this (using pretend numbers):

for each share of Total International:
Europe fund produces $0.58 of income
Pacific fund produces $0.28 of income
Emerging markets fund produces $0.14 of income

Europe fund pays $0.06 in taxes to foreign govts
Pacific fund pays $0.03 in taxes to foreign govts
Emerging markets pays $0.02 in taxes to foreign govts

The total international fund receives $1.00 - $0.11 = $0.89 in income which it distributes to its shareholders. The $0.11 in taxes that its constituent funds paid are irrelevant to the Total international fund owner.

In contrast, if you had owned each of the 3 regional funds, that $0.11 in foreign taxes that the funds had paid would be counted as a credit on your taxes.