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.