Using foreign diversification in both equities and fixed income markets may not deliver higher returns—at least, not consistently—but it does drive down volatility, and thus risk in client portfolio, according to Louis Kokernak of Haven Financial Advisors. The rationale is that foreign stocks have a relatively low correlation with the U.S. market.
Even though that’s not always true, particularly as the global marketplace becomes ever more interrelated, Kokernak said that the European Central Bank is currently “considering quantitative easing, whereas we’re winding down ours. [They’re] two economic spheres going in two completely different directions.”
Kokernak has been using international investing to control for risk since he became an advisor, influenced by the likes of William Sharpe, Harry Moskowitz and Ibbotson Associates, who “all argue for international diversification.” As a result, “Generally our stock portfolios are two-thirds U.S. and one-third foreign. Clearly the U.S. is over-weighted relative to market capitalization, but the foreign component is heavy relative to other advisors.”
Among equity holdings Kokernak uses are DFA funds that emphasize value and smaller cap. Specifics include “VEA, for foreign developed market exposure; VWO, for emerging market exposure; DFIVX, for foreign large-cap value; DISVX, for foreign small-cap; and DFEVX, for emerging market value.”
Bonds are also globally diversified, although “the bond space is a bit more complicated,” said Kokernak. The positions the firm takes in foreign bond markets are in some cases hedged against currency risk and in some cases not. Foreign holdings make up a smaller portion of fixed income portfolios, at a fifth to a quarter, and include ETFs, PIMCO funds and DFA funds. Thanks to the “tremendous amount of innovation in this space in the last ten years,” he said, adding there are plenty of options to choose from, which was not the case in the past.
“There were barely more than a handful in 2004 as there were regulatory hurdles regarding the underlying liquidity of foreign bond holdings. Now there are enough products to satisfy just about any market niche,” Kokernak said. Among the ETFs the firm uses are “IGOV and EMB as core holdings.” PIMCO’s institutional products such as PFUIX and PEBIX are used for developed and emerging markets, respectively. “The developed market products are denominated in other currencies while many of the emerging market issuers are dollar denominated. DFA offers a range of global bond portfolios that are currency hedged. We use a combination of hedged and unhedged products.”
The debate over hedged versus unhedged, said Kokernak, includes the argument that hedged products provide a buffer against “currency risk [that] adds volatility risk for which the investor is not compensated,” whereas “the counter is that currency diversification offers its own hedge against differing economic cycles; there are costs to hedging; and that foreign currency positions offer some insurance risk for movements away from the world’s reserve currency.”
He favors emerging market bonds, in which he over-weights, “an area where I diverge more from the typical investment advisor.” Kokernak said that emerging market bonds make up “approximately 9% of the aggregate bond market, so they’re a real presence.” However, he stays away from frontier markets—Africa and the Middle East—in both bonds and equities. “It’s not a big intellectual sacrifice, [since it makes up only about] 1% of the market,” he said, adding that it’s a relatively inefficient segment of the market “and if active management would deliver, I would be there.”
As it is, since Kokernak said it’s easy to pay a lot for foreign stock and bond management, he sticks with products such as index funds that provide “well below average” costs in underlying management fees.