International ETF Exposure

[Arkad]

I am a passive investor that subscribes to a dollar cost averaging philosophy on broad indexes. Although in my view markets are not efficient and there are plenty of opportunities for bargains, I prefer the simplicity of passive index investing through ETFs. My portfolio is largely made up of S&P and US small cap ETFs.

One issue I am trying to figure out is how much international exposure I want, if any. I am looking at  large-cap international ETF for around 10 to 20 percent of my portfolio (for example, Vanguard's VEU).  As I have thought about this, I have gone back and forth in my thinking:

Pros: International exposure diversifies portfolio, US equities may be overheated increasing attractiveness of other markets/broader exposure.

Cons: Slightly higher fees, large-cap foreign is highly correlated to US S&P anyway, returns over past several years have been dismal (although this is no indicator of future, results), US Large cap stocks have plenty of foreign exposure anyway due to financial globalization.

Does anyone have any thoughts of the usefulness of broad foreign exposure to diversify a portfolio? Are there any pros or cons that I am missing? Part of me thinks that diversification into international ETFs is overrated, but part of my thinks it has a place in a balanced portfolio.

[Dexter]

Hi Arkad, welcome to the Capital Alligator Forum!

Passive indexing with dollar cost averaging can be a very effective investment strategy (especially for people who stick with it).  It sounds like this strategy suits you, so that's great.

I think you've identified a lot of the pros and cons associated with buying an international ETF vs. a U.S. ETF. 

I have a few additional thoughts though....

ETF providers usually construct their funds based on where a company is domiciled.  However, just because a company is domiciled in one country doesn't mean the majority of its revenues and earnings come from that country.  Along these same lines, many of the companies in an International ETF (VEU, for example) also do business in the U.S.  So, some portion of their revenues and earnings are coming from the U.S.

Thus, international and U.S. ETFs are not pure-plays on their respective regions.  So, you can't say that you have exactly 10% international exposure if you put 10% of your portfolio into an international ETF and the rest into U.S. ETFs.  You can't even say that you have 10% international exposure if you put 10% into an international ETF and the other 90% into a U.S. based company that only does business in the U.S.

The only way to know what percentage of revenues and earnings are coming from international vs. the U.S. is to drill down into the companies that are included in these ETFs.  Also, the mix of international vs. U.S. in each of these ETFs will probably change over time as the underlying companies receive more or less revenues/earnings from various countries.  As you can imagine, it could easily be a full time job to track this stuff.

The international ETFs probably do have a higher concentration of international business -- it's just hard to put a number on it without digging into the details. 

Also, the returns of the international ETF would have to be slightly better to overcome the slightly higher expense ratio.  Without performing some kind of valuation, it would be hard to assess relative attractiveness of an international ETF vs. a U.S. ETF.  But this may not be an issue for you if your main goal is to own some businesses that are domiciled outside the U.S.

You probably won't go wrong either way -- i.e., owning 100% U.S. ETFs vs. 80-90% U.S. ETFs / 10-20% International ETFs and rebalancing quarterly or annually.  However, you'll definitely want to factor in trading costs when you make your decision.

[Dexter]

Arkad,

You might enjoy reading some of the work that Horizon Kinetics (http://www.horizonkinetics.com/) has done on indexing and ETFs.

Here is a short piece that HK did on international diversification.

http://www.horizonkinetics.com/docs/InternationalDiversification_June2015.pdf

Hope you're enjoying the 4th of July weekend.

[Dexter]

Check out Jack Bogle's answers to the first two questions in this interview: http://www.marketwatch.com/story/jack-bogles-secrets-to-becoming-a-winning-investor-2016-12-20?siteid=yhoof2&yptr=yahoo


On the index he would pick if he was starting the first index fund again:

Bogle: I would choose the Standard & Poor's 500 Stock Index for the same reasons I picked it in the first place all those years ago. The reality is that it's weighted by the market capitalization of each stock, so if a big stock goes up in value, you don't have to buy any more, it goes up in value by the exact same amount in the fund. It is a very low-transaction costs investment. It's the best index around.

On people who would criticize that choice because the S&P 500 is a U.S. stock index:

Bogle: I'm out on kind of a limb on this, but I realize — and everyone else should know — that in the S&P 500, almost half of the revenues and half of the earnings of those 500 corporations come from outside the U.S. It is an international portfolio, it just doesn't have a stock price that floats in the international market.

So I am happy to have a totally U.S. portfolio, and that is what I happen to do myself.

I can't tell you it's right. I can't say that international won't do better in the future, because it has done so much worse in the past since I first made this statement back in '93. ... You don't need to use international, however, and if you do, keep it below 20% of your portfolio.