An amazing thing happened earlier this week: Vanguard -- the arch-conservative, non-profit fund issuer -- made a massive switch in its central recommendation of what investors should hold as a core allocation.
The news was hidden inside a press release trumpeting the launch of the new Vanguard Total International Bond Index Fund. In fact, it was so hidden, no one noticed. I haven’t seen a single news story; a single tweet; nothing.
And yet, the impact is absolutely massive. It’s a clarion call that you, as a financial advisor, should quickly consider shifting your asset allocation policy in a significant way. Right now.
What’s the news?
Hidden at the bottom of its press release touting the new International bond fund was the following statement:
Because of the diversification benefits international bonds offer, we've added Vanguard Total International Bond Index Fund to our 12 Vanguard Target Retirement Funds, 4 Vanguard LifeStrategy® Funds, and 2 Vanguard Variable Insurance Funds. The new international bond fund represents 20 percent of the fixed-income allocation for each of the funds listed.
Twenty percent of your fixed-income allocation! Bam!
Welcome to the new era.
The average U.S. investor has just about 0 percent exposure to international fixed-income, so Vanguard suggesting 20 percent is a big deal.
Should you adjust your asset allocation program today? What ETFs can you use to do the job? Let’s consider the case.
Vanguard’s Argument
The use of international fixed income in portfolios started coming into focus in 2007, when State Street Global Advisors launched the first international bond ETF, the SPDR Barclays International Treasury Bond ETF (NYSEArca: BWX). International fixed-income solutions existed before this, but they were little loved and little noticed.
Assets and listings expanded from there, driven by ultra-low rates on U.S. Treasuries and rising concerns about the credit worthiness of U.S. debt. Why hold 100 percent of your assets in a country with rising deficits and vanishing payouts?
Rather than jumping on the bandwagon, however, Vanguard took a deliberate approach, deciding to study the question in depth and try to figure out if international fixed income had value for the average U.S. investor.
Its findings – written up in a fantastic white paper about a year ago – are a must-read. The paper found that a long-term allocation to hedged international fixed income substantially lowers overall portfolio volatility. Every time.
Hedged Vs. Unhedged
It’s important to note that Vanguard focused on “hedged” exposures.
ETFs have led the way in developing the international fixed-income market, but a debate has raged over whether you want “currency hedged” exposure to international fixed income or “unhedged” exposure.
In the equity markets, the vast majority of investors utilize unhedged exposure. Most people don’t even think about it, but the return you enjoy in (say) a UK-focused equity ETF depends on both the movement of the local market and the movement of the pound against the dollar. Studies suggest that this currency exposure boosts the diversification benefit of those positions. Moreover, with the dollar largely falling against major global currencies for most of the past decade, U.S. investors have benefited from higher total returns as well.
Equity investors have started to think more about their currency exposure with the success of the WisdomTree Currency Hedged Japan ETF (NYSEArca: DXJ), but still, more than 99 percent of international equity assets are unhedged.
The bond space has always been more mixed, however, and in its white paper, Vanguard found support for the hedging concept. Specifically, it found that an allocation to unhedged international fixed income increased the overall volatility of a portfolio of global stocks and U.S. fixed income; conversely, an allocation to hedged international fixed income decreased the overall volatility of the portfolio. Every single time.
Obviously, some investors will want to make a tactical call on the dollar; if you think the dollar will fall against global currencies, you want unhedged exposure to international bonds. But as a long-term, broad-based allocation, the Vanguard findings are worth studying.
The Vanguard Solution And ETF Options
Vanguard’s new fund capturing this market is called the Total International Bond Index Fund. Trading next week as an ETF under the ticker BNDX, it charges 0.20 percent in annual expenses (the fund is already available in various mutual fund share classes). The fund tracks the Barclays Global Aggregated ex-US Float Adjusted RIC Capped Investable Index (USD Hedged), which basically holds all investment-grade corporate and government international bonds outside the U.S. Its largest weight is in Japan, at 22 percent of the portfolio.
For those looking for broad-based exposure, there is no single alternative in the ETF space. The closest you can come is to piece together the exposure by combining BWX with the SPDR Barlcays International Corporate Bond ETF (NYSEArca: IBND). The costs would be much higher: BWX charges just 0.50 percent in annual expenses, while IBND charges 0.55 percent in fees.
Other alternatives include piecemeal solutions from iShares, PowerShares and other firms, but none offer the broad-based exposure the Vanguard product promises.
Summary
Why is this a big deal?
Consider this: International fixed income is the single largest asset class in the world. It is bigger than U.S. bonds; bigger than U.S. stocks; bigger than international stocks. By Vanguard’s count, fully 35 percent of the world’s total capitalization is invested in international debt.
Vanguard is now saying that effectively all investors deserve to be exposed to this asset class. That’s incredible.
To me, it feels a bit like the equity market felt 20 or 30 years ago, when investors were hugely home-biased in their portfolios. A few decades later, all of us own international stocks.
Am I predicting that in the international bond market overnight? Of course not.
But I am saying this: If the world’s largest index investor thinks most investors should have 20 percent of their fixed-income investments in international bonds, you should consider it too.
And if you don’t, I’m sure some of your competitors will.
Matt Hougan is the global head of content for IndexUniverse, the world’s leading authority on ETFs. Investors interested in Matt’s approach to analyzing ETFs can receive a free two-week trial to IndexUniverse’s institutional-quality ETF Analytics tool by submitting an email to [email protected].