A recent article in the Wealth Management Report of The Wall Street Journal provides recommendations from industry experts on what portion of the portfolio an individual investor should invest in foreign securities. The expert opinions focus on equity, rather than bond or currency, allocation in the portfolio. Although the sample of just seven experts is small, statistics show that opinions do not vary a lot:
So, is a foreign equity allocation in the high 20s percent points appropriate? It depends on whether this brings the benefit of high and uncorrelated returns to the rest of the portfolio. In his bestselling book, David Swensen recommends the following asset allocation as the starting point for individual customization:
|Asset Class||Policy Target|
|Foreign Developed Equity||15%|
|Emerging Market Equity||5%|
|U.S. Treasury Bonds||15%|
|U.S. Treasury Inflation-Protected Securities||15%|
This implies an explicit foreign equity exposure of 20% of the total portfolio and about 28.6% of its equity portion (20% in a portfolio with 70% of “assets that promise equity-like returns”). Swensen also discusses currency exposure that stems from foreign investments:
“Fortunately, finance theorists conclude that some measure of foreign exchange exposure adds to portfolio diversification. Unless foreign currency positions constitute more than roughly one-quarter of portfolio assets, currency exposure serves to reduce the overall portfolio risk. Beyond a quarter of portfolio assets, the currency exposure constitutes a source of unwanted risk.”
Unfortunately, the diversification provided by foreign equities tends to fail when it is needed most. Since the most recent financial crisis, correlations between foreign and domestic equity returns shot up. Vanguard reports that from October 2007 through February 2009, that correlation was 0.93 for developed international markets and about 0.83 for emerging markets.
At the same time, even a domestic equity portfolio has an implicit exposure to foreign markets. That is because about 46% of revenue of companies in the S&P 500® index has been historically obtained abroad. In sum, an explicit allocation of close to 30% of the equity portfolio to foreign securities, which on average experts recommended, may be on the high side.