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.