Hedge Your Currency Risk When Investing Abroad ?

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Doc
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Hedge Your Currency Risk When Investing Abroad ?

Post by Doc » Thu Sep 14, 2017 11:19 am

Alex Bryan, Morningstar wrote:Jack Bogle has made the argument that U.S. investors don't necessarily need to venture outside the U.S. market to get global exposure because most large-cap U.S. stocks have global businesses and yet foreign stocks have greater currency risk than U.S. stocks.
Jeremy Schwartz, director of research at WisdomTree wrote:He (Bogle) did mention that foreign companies have higher risk because you have to take currency risk, which I don't think is true. You can now strategically hedge currencies in a much easier way than you could years ago and that can lower your volatility profile and argue for even more allocations internationally if you take out that currency risk.
http://news.morningstar.com/cover/video ... ?id=825075
Vanguard wrote: ... the fund (Vanguard FTSE All-World ex-US Index) is also subject to currency risk and country risk.
https://personal.vanguard.com/us/funds/ ... undId=0570

So what's a US investor to do?
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by raven15 » Fri Sep 15, 2017 12:14 am

Invest 20% to 50% of stocks in international indices, because historical currency fluctuations have usually placed the minimum volatility point somewhere within that range? As in yes, volatility with 20-50% of stocks denominated in different currencies has historically been less than with 100% of stocks denominated in dollars? I thought that was fundamental and not worth the huge amounts of agonizing thought people put into it.
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Ari » Fri Sep 15, 2017 12:48 am

Putting all of your assets in a single currency seems to me to be the opposite of diversification. I do not hedge my foreign holdings (I'm not an American, though).
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by lack_ey » Fri Sep 15, 2017 1:12 am

You definitely get lower short-term volatility in local-currency terms by hedging, and the cost for hedging developed market stocks is pretty low. With WisdomTree's new funds they hope to turn the cost of partial hedging effectively negative (being additive to returns) by employing a currency trading overlay strategy that swings a fund somewhere between fully hedged to unhedged based on traditional currency trading signals like carry/momentum/value. But I don't think the question is about those WisdomTree funds specifically.

In any case, for the long term, if not withdrawing from equities any time soon, then short-term vol is actually not that important or relevant anyway so you shouldn't care. In fact, more volatility for a given long-term geometric return is actually better on average if making contributions.

In drawdown stage, most don't have heavy equity allocations anyway (in particular, foreign equity), and how much benefit is there really to hedging say 15% of your portfolio? And if you think beyond portfolio effects to spending and look beyond volatility to see the direction of effects, if the home currency is that strong and depressing unhedged foreign equity returns, then this in practice probably means cheaper goods and especially vacations abroad anyway, and probably decent local equity returns. That's not much of a real problem. The hedging reduces the downside of a situation that probably isn't bad. On the other hand, if the local currency is weak, you're likely more liable to need diversification benefits, and you get that with stronger foreign currency exposure. So there's a real argument to having some foreign currency exposure anyway.

In any case, it doesn't seem worth avoiding like the plague.

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TD2626
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by TD2626 » Fri Sep 15, 2017 1:55 am

In my opinion:

-History appears to show that the value of dollar has roughly a 9% annual SD. (See this thread that discusses this towards the second page: viewtopic.php?f=10&t=222809)

-Currency risk is thought to be uncompensated

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.

-Currency risk hedging seems to be more reasonable to do in bonds than in stocks - in bonds, currency moves would dwarf returns, but in stocks, it is a much smaller component

-The MPT-based models are very sensitive to inputs and an investor could reasonably put anywhere from about 20% to close to cap weight of their portfolio in international. A risk tolerant, long term investor looking for simplicity (and the freedom of not having to rebalance) may wish to consider Vanguard Total World, a cap weight international fund. Otherwise, having 30-40% unhedged international seems reasonable.

-In my opinion, the costs of hedging likely wouldn't be worth the benefit for stocks. Currency diversification could provide some black swan protection - but do beware of the added risk and the volatility drag from this significant and uncompensated risk.

Also - this Vanguard paper may be helpful: https://personal.vanguard.com/pdf/ISGCMC.pdf
Last edited by TD2626 on Fri Sep 15, 2017 12:40 pm, edited 1 time in total.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Valuethinker » Fri Sep 15, 2017 3:01 am

TD2626 wrote:
Fri Sep 15, 2017 1:55 am
In my opinion:

-History appears to show that the value of dollar has roughly a 9% annual SD. See this thread that discusses this towards the second page: viewtopic.php?f=10&t=222809)

-Currency risk is thought to be uncompensated
-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.

-Currency risk hedging seems to be more reasonable to do in bonds than in stocks - in bonds, currency moves would dwarf returns, but in stocks, it is a much smaller component

-The MPT-based models are very sensitive to inputs and an investor could reasonably put anywhere from about 20% to close to cap weight of their portfolio in international. A risk tolerant, long term investor looking for simplicity (and the freedom of not having to rebalance) may wish to consider Vanguard Total World, a cap weight international fund. Otherwise, having 30-40% unhedged international seems reasonable.

-In my opinion, the costs of hedging likely wouldn't be worth the benefit for stocks. Currency diversification could provide some black swan protection - but do beware of the added risk and the volatility drag from this significant and uncompensated risk.

Also - this Vanguard paper may be helpful: https://personal.vanguard.com/pdf/ISGCMC.pdf

This is a very cogent and well made argument. Thank you.

I learned a lot from this post.

The only thing I would add is that if you are not a US-based investor, home market bias adds a lot more risk/ cuts expected return. You are better off being globally diversified in your equities (fully diversified). That's least true for Canadians given the high correlation with the US market. However the Canadian stock market is c. 40% financials and c. 30-40% natural resource and energy companies. The lack of sectoral diversification is a real issue (and will be more so when the housing bubble blows, which I believe it will).

On bonds as a non US person you should aim for risk free bonds in your own currency. Not all government bonds are risk free, even if the chance of say, Italy, defaulting is infintesimal, it is not zero. So a global investment grade government bond fund that hedges back into EUR is not a bad idea if you are a Eurozone based investor.

In the absence of such alternatives a USD denominated bond fund (which hedges into USD, or does not) that invests globally in investment grade government bonds, is not a bad bet. ishares in Europe (and now Vanguard) certainly offer such products as ETFs, although as ever your tax position will drive their appeal.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Lauretta » Fri Sep 15, 2017 3:47 am

I really don't think there is a simple answer nor any consensus on this. Some quants have made the case for at least partially hedging your exposure.
https://www.aqr.com/library/aqr-publica ... fx-hedging
Many disagree. People at Wisdom Tree do strategic hedging i.e. time their hedging. People like Meb Faber say the opposite (that you should either be permanently hedged or permanently unhedged).
This question is all the more relevant to me because I am a EU based investor, but I have come to the conclusion that there's no 'true' answer for what is best. For the moment I personally solve it by underweighing the US and overweighing EU stocks, because I believe in mean reversion and I think it very unlikely that US stocks will go on outperforming indefinitely (I actually very much fear the opposite). But that's just what I came up for myself and what I personally feel comfortable with.
Last edited by Lauretta on Fri Sep 15, 2017 4:10 am, edited 1 time in total.
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Lauretta » Fri Sep 15, 2017 3:52 am

TD2626 wrote:
Fri Sep 15, 2017 1:55 am

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%
I am no expert at all in this, but the paper below from AQR has in the Abstract 'The correlation between foreign currencies and domestic equity returns varies over time, but is positive on average and rarely significantly negative.'
https://www.aqr.com/library/aqr-publica ... fx-hedging
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by JBTX » Fri Sep 15, 2017 4:45 pm

I typically don't buy hedged international. I have one active fund that is hedged.

My thinking, perhaps ignorant and far less intelligent than the above posts, is that currency could actually be a bit of a diversifier. If the dollar is strong then US market and economy are probably doing well. If dollar is weak then us economy is weaker and international may be better. But that is a complete anecdotal hunch and could be totally wrong.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Valuethinker » Fri Sep 15, 2017 5:21 pm

JBTX wrote:
Fri Sep 15, 2017 4:45 pm
I typically don't buy hedged international. I have one active fund that is hedged.

My thinking, perhaps ignorant and far less intelligent than the above posts, is that currency could actually be a bit of a diversifier. If the dollar is strong then US market and economy are probably doing well. If dollar is weak then us economy is weaker and international may be better. But that is a complete anecdotal hunch and could be totally wrong.
In the absence of any empirical studies, it's best to assume that relative currency movements are basically random or at least uncorrelated with stocks (I believe the actual historic correlation is somewhat negative ie a fall in currency leads to a rise in the market in its own currency terms*).

If you don't hedge bonds then you have a currency volatility which will exceed your returns. Purchasing Power Parity does not hold (or holds weakly in the long run) so the difference in inflation rates between 2 countries is not fully priced in (in a perfect capital market, the real returns on the bonds should be the same, but they are not).


* consider the Brexit vote on 23rd June 2016. This surprised the market, and sterling fell by about 10% overnight (literally dropping most of that in 1 hour as the results came in).

The FTSE 100, which is composed mostly of multinationals with large overseas earnings (the top 10 companies are 44% of the index and include BP, Shell (oil), Glaxo SK, Astra Zeneca (pharma) etc.). It duly rose about 6-7%, which is just about the share in profits in those companies which are earned overseas.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Doc » Fri Sep 15, 2017 5:41 pm

Here's a 3 month rolling return chart for the hedged and unhedged version of the Tweedy, Browne Global Value Fund

Image

Here's the link to the Morningstar chart if anyone wants to play with the rolling return period.

http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D
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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Osp62 » Fri Sep 15, 2017 5:46 pm

TD2626 wrote:
Fri Sep 15, 2017 1:55 am

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.
Not sure what you mean by no correlation between currency risk and market risk - USDollar currency value and performance of Tot international stock are VERY correlated for US dollar investors.

Furthermore, the relative performance of US stock vs non-US stock in US dollar terms seems to be very correlated with the performance of USD against a weighted basket of foreign currencies. So, if the USD is strong US Total stock does better than Total International stock and if the US dollar is weak US Total stock does worse.

Last week or so, FT reported that USD was down about 12% against other currencies in 2017 and it is interesting to note that Total International has outperformed US stock by about 10% this year. If you look at the last five years - US dollar has been very strong and this might explain the relative weaker performance of Total International stock vs Total US stock over the last 5 or so years.

It seems that for USD investors, total international stock is becoming more and more just a short position in the USD owned via a stock mutual fund. It may be a fine way to hedge against the US dollar but I doubt if this is really the intention of Total international buyers.

One wonders how much of the 'marketing' around the benefit of international investing is because it makes more money for fund companies and advisors ( who have something to advise beyond US Total stock) and allows the fund companies to diversify outside their core US market business given the commoditization and low fees associated with US stock investing.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by JBTX » Fri Sep 15, 2017 6:48 pm

Doc wrote:
Fri Sep 15, 2017 5:41 pm
Here's a 3 month rolling return chart for the hedged and unhedged version of the Tweedy, Browne Global Value Fund

Image

Here's the link to the Morningstar chart if anyone wants to play with the rolling return period.

http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D
That's actually the one hedged fund I have.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by JBTX » Fri Sep 15, 2017 6:50 pm

Valuethinker wrote:
Fri Sep 15, 2017 5:21 pm
JBTX wrote:
Fri Sep 15, 2017 4:45 pm
I typically don't buy hedged international. I have one active fund that is hedged.

My thinking, perhaps ignorant and far less intelligent than the above posts, is that currency could actually be a bit of a diversifier. If the dollar is strong then US market and economy are probably doing well. If dollar is weak then us economy is weaker and international may be better. But that is a complete anecdotal hunch and could be totally wrong.
In the absence of any empirical studies, it's best to assume that relative currency movements are basically random or at least uncorrelated with stocks (I believe the actual historic correlation is somewhat negative ie a fall in currency leads to a rise in the market in its own currency terms*).

If you don't hedge bonds then you have a currency volatility which will exceed your returns. Purchasing Power Parity does not hold (or holds weakly in the long run) so the difference in inflation rates between 2 countries is not fully priced in (in a perfect capital market, the real returns on the bonds should be the same, but they are not).


* consider the Brexit vote on 23rd June 2016. This surprised the market, and sterling fell by about 10% overnight (literally dropping most of that in 1 hour as the results came in).

The FTSE 100, which is composed mostly of multinationals with large overseas earnings (the top 10 companies are 44% of the index and include BP, Shell (oil), Glaxo SK, Astra Zeneca (pharma) etc.). It duly rose about 6-7%, which is just about the share in profits in those companies which are earned overseas.
My thought is in the event the US market tanked and/or had an unexpected period of inflation that international currency would appreciate. It isn't a likely scenario and one hat really hasn't really happened in the past. Think Japan.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by TD2626 » Fri Sep 15, 2017 7:50 pm

Valuethinker wrote:
Fri Sep 15, 2017 3:01 am
TD2626 wrote:
Fri Sep 15, 2017 1:55 am
In my opinion:

-History appears to show that the value of dollar has roughly a 9% annual SD. See this thread that discusses this towards the second page: viewtopic.php?f=10&t=222809)

-Currency risk is thought to be uncompensated
-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.

-Currency risk hedging seems to be more reasonable to do in bonds than in stocks - in bonds, currency moves would dwarf returns, but in stocks, it is a much smaller component

-The MPT-based models are very sensitive to inputs and an investor could reasonably put anywhere from about 20% to close to cap weight of their portfolio in international. A risk tolerant, long term investor looking for simplicity (and the freedom of not having to rebalance) may wish to consider Vanguard Total World, a cap weight international fund. Otherwise, having 30-40% unhedged international seems reasonable.

-In my opinion, the costs of hedging likely wouldn't be worth the benefit for stocks. Currency diversification could provide some black swan protection - but do beware of the added risk and the volatility drag from this significant and uncompensated risk.

Also - this Vanguard paper may be helpful: https://personal.vanguard.com/pdf/ISGCMC.pdf

This is a very cogent and well made argument. Thank you.

I learned a lot from this post.

The only thing I would add is that if you are not a US-based investor, home market bias adds a lot more risk/ cuts expected return. You are better off being globally diversified in your equities (fully diversified). That's least true for Canadians given the high correlation with the US market. However the Canadian stock market is c. 40% financials and c. 30-40% natural resource and energy companies. The lack of sectoral diversification is a real issue (and will be more so when the housing bubble blows, which I believe it will).

On bonds as a non US person you should aim for risk free bonds in your own currency. Not all government bonds are risk free, even if the chance of say, Italy, defaulting is infintesimal, it is not zero. So a global investment grade government bond fund that hedges back into EUR is not a bad idea if you are a Eurozone based investor.

In the absence of such alternatives a USD denominated bond fund (which hedges into USD, or does not) that invests globally in investment grade government bonds, is not a bad bet. ishares in Europe (and now Vanguard) certainly offer such products as ETFs, although as ever your tax position will drive their appeal.
Thanks - and good points about non-US investors. I made the mistake of making my post largely envisioning a US based investor, my apologies. Obviously the case for Total World is far stronger for non-US investors. I feel the "what if you lived in a small, developing economy with a small stock market" situation is a good one to mention to those who feel 0% international is a good idea.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by TD2626 » Fri Sep 15, 2017 8:02 pm

Osp62 wrote:
Fri Sep 15, 2017 5:46 pm
TD2626 wrote:
Fri Sep 15, 2017 1:55 am

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.
Not sure what you mean by no correlation between currency risk and market risk - USDollar currency value and performance of Tot international stock are VERY correlated for US dollar investors.
Do you have a source for this? It seems as though most in this thread feel that correlation should be low over the long term (decades). (It may be high in the short term but that is not relevant to long-term investors). The article I mentioned (https://personal.vanguard.com/pdf/ISGCMC.pdf) seems to suggest low correlations - see Figure 6.

Osp62 wrote:
Fri Sep 15, 2017 5:46 pm
One wonders how much of the 'marketing' around the benefit of international investing is because it makes more money for fund companies and advisors ( who have something to advise beyond US Total stock) and allows the fund companies to diversify outside their core US market business given the commoditization and low fees associated with US stock investing.
Vanguard operates essentially as a mutual-like company; the goal is not to make a profit but to provide good investments at low cost to investor-owners. They are advising relatviely high international compared to their for-profit competitors. Also, with the low costs of Vanguard Total International index (and similar funds), the added cost of international may be only basis points.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by TD2626 » Fri Sep 15, 2017 8:18 pm

Lauretta wrote:
Fri Sep 15, 2017 3:52 am
TD2626 wrote:
Fri Sep 15, 2017 1:55 am

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%
I am no expert at all in this, but the paper below from AQR has in the Abstract 'The correlation between foreign currencies and domestic equity returns varies over time, but is positive on average and rarely significantly negative.'
https://www.aqr.com/library/aqr-publica ... fx-hedging
Thank you for quoting that paper. It was quite interesting. The paper did confirm that currency risk appears to be about half of market risk (though they used slightly different numbers). However, I feel that they do not fully account for the costs associated with hedging. Further, I feel that they do not fully account for the fact that for most, international equity is probably their only foreign currency exposure. The vast majority of their other exposures (domestic stock, domestic bonds, human capital, real estate/house, and so on) are in domestic currency. Maybe having a little currency diversification by keeping international equity unhedged could be a good thing in the event of a black swan affecting their home currency. That being said, currency risk is a very unfortunate "risk without reward" situation. In an unreasonable, worst case scenario, where correlations approached 1.0, then risks would be summed (18% + 9% = 27%) and then the case for unhedged international would would be far weaker. I feel that correlations should probably be fairly small (say, 0.1) - hopefully small enough to approximate as zero-ish and add risks in quadrature. However, it's hard to know in advance - they could be positive or negative, and they could be substantial.

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Re: Hedge Your Currency Risk When Investing Abroad ?

Post by Osp62 » Sat Sep 16, 2017 2:02 pm

TD2626 wrote:
Fri Sep 15, 2017 8:02 pm
Osp62 wrote:
Fri Sep 15, 2017 5:46 pm
TD2626 wrote:
Fri Sep 15, 2017 1:55 am

-However, with a virtually no correlation between currency risk and market risk, the risks should add in quadrature, so if market risk was about 18% SD and currency risk was 9%, then total risk would be sqrt(18^2 + 9^2) = 20.1%

-The relatively low correlation between domestic and international should partly make up for this currency risk when running portfolio optimization based on modern portfolio theory. This assumes returns from different country's markets are similar over the long run.
Not sure what you mean by no correlation between currency risk and market risk - USDollar currency value and performance of Tot international stock are VERY correlated for US dollar investors.
Do you have a source for this? It seems as though most in this thread feel that correlation should be low over the long term (decades). (It may be high in the short term but that is not relevant to long-term investors). The article I mentioned (https://personal.vanguard.com/pdf/ISGCMC.pdf) seems to suggest low correlations - see Figure 6.
Just look at the relative performance in 2017. Total international has had returns of about 20% while US stock has had returns of around 10% so far - and the US dollar has dropped by about 10% against the weighted basket of foreign currencies. Also anecdotally it seems that the one could attribute much of the last 5 years of underperformance by foreign stocks vs US stocks to the usd strength.

Intuitively as well this makes sense. The US market has a slightly higher long term return in local currency than other markets ( it is better developed, better corporate governance, less fraud, better legal enforcement than the average of the rest of the world) as other markets have some uncompensated risk. In addition the US dollar investor is exposed to the risk of US dollar appreciating vs other currencies.

Regarding correlation the real issue to me is not the correlation that helps you decide whether or not to hedge the foreign equity portfolio. The real issue is whether or not you need foreign equity as part of your portfolio. It may be true that it may not be worthwhile hedging the foreign equity portfolio but the real question is - does replacing US equity with International equity really help a US based investor who has almost all his/her future liabilities denominated in US dollar.

The correlation that we need to look at is The CORRELATION between the return on USD against a weighted basket of foreign currencies by equity market cap VS the DIFFERENCE IN RETURN between US equity and international equity. Intuitively, it seems that these would be highly correlated (2017 data seems greater than 80%, last 5 years is also extremely high) - if USD is strong then US equity will have higher returns than international equity. I have not seen this data over the long term and don't feel like doing the spreadsheet myself but would definitely appreciate if someone who has already done it can share it.
Osp62 wrote:
Fri Sep 15, 2017 5:46 pm
One wonders how much of the 'marketing' around the benefit of international investing is because it makes more money for fund companies and advisors ( who have something to advise beyond US Total stock) and allows the fund companies to diversify outside their core US market business given the commoditization and low fees associated with US stock investing.
TD2626 wrote: Vanguard operates essentially as a mutual-like company; the goal is not to make a profit but to provide good investments at low cost to investor-owners. They are advising relatviely high international compared to their for-profit competitors. Also, with the low costs of Vanguard Total International index (and similar funds), the added cost of international may be only basis points.
Just because you are a "mutual-like" company does not mean that management does not want to diversify their business beyond US equity (sp500 and tot stock) where competitors are matching their price. They also need to grow the business overseas so they need to develop their non-US equity and bond fund management businesses especially because these would be domestic equity and fixed income funds for their non-US customers. Doesn't it make sense to get scale in your non-US funds through your US customers and then use the scale obtained in non-us funds to then acquire non-us customers. This is a perfect strategy for any US fund management company that wants to grow their business beyond what is possible with US customers.

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