My 3 Rules for Foreign Stock Investing

My 3 rules for foreign equity investing:

1. Do not hedge the foreign currency exposure.
2. Index most (or all) of your foreign equity.
3. Allocate no more than 10-20% of your portfolio to foreign equity.

The link below will take you to a report with a TON of very useful information.

CREDIT SUISSE GLOBAL INVESTMENT RETURNS YEARBOOK 2012

I will focus on just one important finding in the report above that is somewhat controversial, and I will take it a step or two further.

RULE #1 - Do NOT Hedge


Bottom line, currency hedges don't pay off in the very long term for investors.  Thus, investors from 401(k)s and IRAs, to endowments and pension funds should NOT attempt to hedge these risks.  Here is the most important quote from this report,

"currency exposure of foreign equities is a valuable benefit."  

Many pension funds and endowments hedge their currency risks.  This is a mistake, as the expense outweighs the benefits.  In fact, the currency swings of foreign equity are exactly what creates "diversification" within a large diversified portfolio.

I have confirmed this with my own analysis.  Utilizing classic Harry Markowitz Modern Portfolio Theory via a mean-variance optimizer you can find the efficient frontier using asset class indexes.  You can use the MSCI EAFE Index as the foreign equity piece.  After finding the optimal portfolio (the portfolio on the efficient frontier that maximizes the risk/return trade-off), switch the foreign equity index to MSCI EAFE Hedged Index.  You will find that this makes the entire efficient frontier contract (reduces returns and increases risk).  Case closed in my opinion.  Don't hedge foreign currency risks within a diversified portfolio.

RULE #2 - Index

This is also a reason to index foreign equity exposure in a diversified portfolio since an active manager may take it upon themselves to hedge currency exposures.  Hedging the currency fluctuations defeats the purpose of owning foreign equity in the first place.  Plus, foreign markets are becoming more and more efficient.  This has made it tougher and tougher over time for active foreign equity managers to beat an index fund.

RULE #3 - Allocate 10-20%

Another important consideration is that investing in foreign equities is more expensive than investing in domestic equities.  Expenses are the worst enemy of investors.  Thus, foreign equity should be used only up to the extent that it expands the efficient frontier.  When in doubt, use the smaller amount. Using the same mean-variance optimization technique mentioned above, I have found a little foreign equity is all you need.

The beneficial amount of foreign equity needed is smaller than many investors believe since foreign equity markets are highly correlated with US equity markets during times of stress (meaning foreign stocks tend to go down when US stocks go down).  I have found having more than 20% of a US-based portfolio allocated to foreign equity begins to harm overall portfolio returns due to the contraction of the efficient frontier and the increase in investment expenses.  Over the past 20 years, foreign equity returns have been lower than US equity returns with higher volatility.  You can see this in a previous post of mine (just follow how the black square moves in the chart over time). Thus, after factoring in expenses, a little foreign equity goes a long way in diversifying a US-based investment portfolio that utilizes an annual re-balancing strategy.

Note: I first performed the above analysis 14 years ago.  I'd love it if someone could re-run the analysis and confirm my results.

6 Months of Blogging - thanks for reading!

Tomorrow marks the 6 month anniversary of the Investor Cookbooks blog!
I'd like to say thank you to all of my readers!  Here are some stats about the blog.

• 2600 page views
• Readers from every continent (except Antarctica)
• The top 5 countries are:

1. US (76%)
2. Russia (5%)
3. Germany (4%)
4. UK (2%)
5. Norway (1%)

• Most read posts:

1. You Can't Spell "DUMBASS" Without "MBA"
2. Investment Performance Persistence Improbable
3. Mutual Funds Without Morals
4. GOLD is Just another Four Letter Word
5. Everything You Need to Know About Investing, Almost
6. Capitalism Without Capital: Why Executive Stock Options Should Be Outlawed
7. Are you putting your investment advisor's kids through college?
8. College Endowment and Public Pension Fund Returns Are Not Good
9. The HOKEY POKEY is NOT an investment strategy
10. The Eurozone Will Survive When PIGS Fly

• Universities that have recommended my blog to finance students:

Fidelity Freedom Funds Aren't "Free" But Are "Dumb"

Fidelity Investments is known as "Fido" on Wall Street. Maybe it's because their target date retirement funds are dogs?  Fido is known for its actively managed stock mutual funds.  Peter Lynch became famous as the index-beating manager of the Fidelity Magellan fund. And while Magellan has struggled since Peter retired some 20 years ago, Will Danoff and Joel Tillinghast have quietly carried the torch since Peter departed.

Fido still sports a few funds with long impressive track records. Of course, they should have at least a few good track records since they have 259 funds. Exactly 12 of Fido's funds (or less than 5%)  have earned a 5-star rating from Morningstar.  I could see how it would be an easy sell for Fidelity to convince investors to plunk money into their Fidelity Freedom line of target date retirement funds.  Just pick one Freedom fund and Fidelity will allocate your money among the many good Fidelity funds for you.  Unfortunately, Fidelity does not do that.  Instead, Fidelity abuses the Fidelity Freedom target date mutual fund shareholders by using their money as seed money to start new and untested funds with expense ratios much, much higher than the Fidelity Spartan Index Funds.

I've always wondered, "how Fidelity could possibly grow to 259 mutual funds?"  I never could figure out why anyone would invest in a new and untested Fidelity fund when you could place your money with Will Danoff in the Fidelity Contrafund or Joel Tillinghast's Fidelity Low-Priced Stock Fund.  Both gentlemen have managed their funds for more than 20 years and both sport  impressive index-beating track records.  Or better yet, why not put your money in the very low cost Fidelity Spartan Index Funds?  Then, you won't have to keep tabs on Will and Joel's own retirement plans and can focus on your own.

I have finally figured out Fidelity's dirty little secret for funding the launch of new and untested mutual funds.  The Fidelity Freedom target date funds allocate money to Fidelity's new funds.  I took a close look at Fidelity Freedom 2035 Fund and was shocked to discover:

College Endowment and Public Pension Fund Returns Are Not Good

Most college endowments and public pension funds are plowing more and more money into complicated and expensive "alternative investments" such as hedge funds and private equity in a failed effort to boost returns.  However, my analysis, combined with a recent study of college endowment fund returns and a study of public pension returns, proves most would  be better off if they simply indexed all their money.  In fact, my simulation of index fund returns would have placed easily in the top 25% of all college endowments.

	1-year	5-year	10-year
Median Public Pension Fund	21.6%	4.7%	5.7%
Median College Endowment	19.8%	4.6%	5.5%
Simulated Index Fund Returns*	22.3%	5.8%	6.2%

Perhaps a difference of 0.5% may not seem like much, but it is HUGE when one considers the dollar amounts involved.  A difference of just 0.5% per year over 10 years amounts to:

Feds with Benefits

Apparently, the benefits are so good working for the federal government, that the Congressional Budget Office has determined that federal workers enjoy 16% more in total compensation than workers in the private sector on average.  Most companies no longer offer a pension plan, and many small businesses don't even have 401(k) plans.  But, the federal government has both - and they are good ones.

In my opinion, the federal government offers the best 401(k) plan in the U.S. called the Thrift Savings Plan (TSP).  There is no question the TSP has the lowest expenses among all retirement savings plans.  This is one example of the federal government doing something better than anyone else.  If you want to know how to make the TSP work best for you, check out my book, "The Federal TSP Cookbook."  You can buy it on Amazon.com or BarnesAndNoble.com.

If you buy it direct from my publisher, CreateSpace (<---just click there) and enter this discount code "R82HTEXM" you can buy it for 25% off the list price (about $15).

Feel free to share this discount code and link with everyone you know who works for the federal government.  Happy investing!