Gus Sauter on the Sweet Spot for International Allocation

The Vanguard CIO discusses the firm's decision to increase the international weighting in its target-date funds to 30% from 20%.

Morningstar Manager Insights on Morningstar.com Gus Sauter, Chief Investment Officer, The vanguard Group-Part 2 Gus Sauter on the Sweet Spot for International Allocation Interviewer: Speaking of asset allocation Vanguard made an announcement today regarding changes to your target date retirement line up which increases the waiting of the international exposure from 20% of equities to 30% of equities. What is the say about what about what vanguard thinks as the ideal asset allocation, ideal domestic international allocation for a portfolio? Gus Sauter: Well we continue to do research on our target date funds as well as other funds and we did feel that we could enhance the versification of it by increasing the international weight but I should say that if we do not expect greater terms from an international investment we think the advantage of the investment internationally is to gain broader the versification and I’ll say that with a caveat that we know correlations have increased between domestic equities, international equities and at the same time we know that during times of crisis that the correlations tend to go to one. Nevertheless if you get some advantage from diversification, some is better than none so we look for kind of the sweet spot on the efficient frontier if you will to try to figure out what an appropriate allocation to international equity should be and what we found was that it’s really probably more centered around 30% than 20% and so we’re increasing that allocation again not because of expected increase in the turns but because we think we got a little bit lower volatility in the overall portfolio. Interviewer: Um-hmm. If correlations are closer between the domestic international stocks and expect the return isn’t likely to be in your view, isn’t likely to be really very different, where’s the versification coming from? Gus: Well I think you know you look at different countries and different countries do have different fortunes and you know look at Australia for one Australia is actually perform quite well over the last decade while the rest of the world in the developed space has been flat and so you’re getting the diversification because different economies are growing differently and into some extent different countries have different industry waiting than you would have and you so Australia has been growing quite rapidly because of it’s resource based economy and so by including Australia in a portfolio you’re getting a bit more of an exposure to resources which has been beneficial over the last decade. No telling that it will in the future we don’t know exactly how old the dynamics will play out but it stands to reason from theory and from what we would experience that including additional country exposure does help diversified portfolio. Interviewer: And the other side of the coin is that you can argue that if you really want a globally weighted portfolio you should have a lot more in international why not have more in international? Gus: Now we think well I mean just mathematically you’re looking at the maximum advantage diversification if you did peak out at roughly 30% at the same time we think it’s important to maintain a home bias and again I’ll give you the example of Australia we just happen to be there so I was encountering this and Australia has had a successful economy over the last decade and at the same time the stock market has reflected that. The world stock market really is flat over the last decade reflecting less robust economic development and the rest of the developed world and if if you were in Australian investor and you cap weighted your equity exposure you would have 2% of your investment Australia. Well so basically you have a flat portfolio at the same time your country’s wealth is going up and you wouldn’t’ be participating in that. So you want a home bias to your country because really most of your expenditures are going to be in your country as well so the worst thing that would happen to you is if you are underweighted in your home country and it does extremely well and you’re just not participating with that. Your ability to finance your future is just much less so home bias is very important for all us in all countries. Interviewer: Another change that you’ve made recently in Vanguard is you’ve gradually moved the Tool International Stock market Index from a fund of funds to a fund securities directly. Now a fund that’s going to track another benchmark, I’m wondering why you made particularly this most recent change to change the bench marketing Tool International Stock Marketing Index? Gus: Well in this kind of reflects the ongoing nature of doing research and enhancing portfolios as we go when we moved away from the fund of funds concept it really opened up a new door for us so that we could start thinking more broadly. We didn’t have some of these other closures available to us in the form of other funds and we didn’t have Canada and Israel and small caps available to us so we couldn’t really incorporate that into the fund of funds concept. So now that we are investing directly in equities, we can include all of these other investments and from a theoretical standpoint again on the argument of diversification it makes sense to include on all of these other stocks that haven’t been included previously so it’s really again just to moderate return and hopefully reduce the risk a little bit, not really, we’re not projecting higher returns hopefully just a little less volatile.