How Much Foreign Equity Exposure Do Investors Need? (Podcast Transcript)

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Summary

Editors' Note: This is the transcript version of the podcast we published last week. We hope you find it useful.

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Jonathan Liss [JL]: For reference purposes this podcast is being recorded on the morning of Wednesday, November 13, 2019.

Many of you will be familiar with today's guest, Victor Haghani. Victor appeared on episode nine of Let's Talk ETFs, in an episode titled, Past Results, Future Returns: A Smart Beta Skeptic Speaks. If you haven't already listened to that episode, I highly recommend you go back and do so when you have a chance.

For those that are less familiar with Victor and his work, he is a 35-year veteran of the investment management industry. He is currently the Chief Investment Officer of Elm Partners, which he founded in 2011. From Salomon Brothers in the 80s to long-term capital management in the 1990s, Victor has often found himself at the center of the action in the investing world.

Anyway, let's get straight into it here. I think most people will be familiar with you at this point. Victor, welcome back to the show. I'm glad you're able to rejoin me so soon.

Victor Haghani [VH]: Thanks, Jonathan. A pleasure to be here.

JL: Yeah, and I think the topic that we're going to discuss today, which is based on a couple of recent articles that you've written, both on your site, and then you posted to Seeking Alpha. Also, that got some interesting comments, and a nice amount of feedback on the site, is international equity allocation, whether it really is as important as the academic literature has shown, whether it's important to increase returns, whether it's important to lower risk.

Before we get into that though, you've been writing these kinds of long, more erudite academic pieces for a while now. With the last discussion we had around smart beta was after you had written a really great piece about smart beta also. And I just wanted to say I find it very unique and refreshing that you continue to take a step back and produce these pieces of long-form research, where you question the sacred cows of modern portfolio theory? What is it about doing this sort of long-form research that you think is so appealing to you? And why do you keep coming back to it?

VH: The general goal of what we're trying to do is trying to distill a lot of other people's thinking down into, essential blocks with little repetition and as little complexity as possible. And it's a really sort of that, as people say that you never learn something as well as you do when you try to teach it. And that holds for this sort of thing where I just feel, and my partner, James White, does, too, that we're just learning so much as we attack some of these problems with the idea of not coming up with original thoughts, but really trying to distill the thoughts of really smart and experienced people down to what we think are the essential.

So it's that. You mentioned, long form. We tend to think of it as really short form. Some of our things have gotten a little bit longer. The factor note was one of our longest ones. But when we do start - when we try to write these our starting point is, say let's try to do this in two pages if we can, ignoring charts. And we've been less successful at that in the last few notes, but the one just prior to this where we talked about home bias was really short one. That was more our normal length.

JL: Yeah, sure. No, that's true. And I guess it's all relative in terms of the length, the pieces here. But yeah, I think about the kind of stuff I often see where people will just write three to five paragraphs about why you should be long or short a specific stock. And so, something that's well researched and heavily footnoted, feels like even when you are successful, and you're able to get it into just two pages or so feels like they're pretty weighty the words that you put into those two pages.

VH: Yes, no, that's true. And indeed, the one that we're talking about today is - couldn't really - doesn't really qualify as a short note. A little bit longer than that.

JL: Definitely. Okay, cool. So let's get into your piece. It's called there's no place like home, the case for and against extreme home bias and equity investing. First of all this is an incredibly important piece for anyone that considers themselves a serious investor or a serious asset allocator. The basic premise that you lay out is that despite the relative outperformance of U.S. domiciled equities, over international ones over the past decade or so - 170% outperformance, to be exact. So really significant. U.S. investors should continue to be properly diversified to international equities. At its core, is this an argument against any sort of active management or rotation strategy in favor of simply holding the market portfolio at all times.

VH: Well, I think that those are separable. So what we're trying to address in this note is your starting point, is your baseline. So then once you have your baseline, you may decide that you want to vary your allocations, but then that would be relative to your baseline. And so we view it as come up with your baseline. And then if you think the expected returns are higher or lower in certain regions or buckets, it could make sense to overweight or underweight those buckets, but first come up with your baseline, and then think about over or under weighting it.

So no we don't we don't view it that we view this thing as agnostic towards whether you're going to be dynamic or static in your asset allocation. It's how to come up with the starting point for your asset allocation. And as you know we're advocates of dynamic asset allocation at Elm Partners. We believe that, for instance, cyclically adjusted earnings yield is a good long-term predictor of expected return or the real expected return of different stock markets.

And so we believe that relative to your baseline that you should generally overweight regions and stock markets where earnings yields are higher relative to those where earnings yields are lower.

JL: Sure. And again, this is an approach that I believe you described as active passive. So you're taking passive indexed products, and then you're making some adjustments, at least around the margins in terms of allocations. But so just to be clear here, you have extreme own [ph] bias in the title. And so the argument would be if, let's say the correct allocation is, let's, just for simplicity sake, say 50-50, between U.S. and ex-U.S. equities. When you do those calculations about expected returns, you'd maybe bump it to 55-45 or 60-40. We're not talking about all or nothing kinds of allocations here.

VH: Yes, that's our view. Yes, exactly.

JL: Sure. And generally speaking, assuming let's say those expected returns are roughly equal. And I'm sure that does happen, at least on occasion, what's your recommendation here for somebody who, let's say, is able to take on the risk, has 20-30 years. Is your recommendation to simply match the global portfolio in terms of market cap and say, okay, the U.S. is 40% of the global market cap thus it should be 40%; Europe's another 30%; Asia's another 20%, et cetera. Or is there a more kind of nuanced approach you're taking here?

VH: Well, we think that, that would be fine. So we're not advocating that but we think that's a fine kind of solution. What we think is a little bit better than that is to try to take into consideration a few more nuances. So for instance, one nuance is that the index providers are making these float adjustments. Now the float adjustments are important for really big investors that have billions and billions to put to work and they need to be sort of balanced out where liquidity and investability makes it possible. But for regular investors, you can be you don't need to take account of their free float adjustments and their investability adjustments. So that would be one thing.

Another thing is that we talked about in the note is that for U.S. investors and for investors in other places like for Australian investors, there can be some small benefits to investing at home in terms of tax and transactions costs. And even a small amount of tax friction, for instance can, if it's in favor of investing at home can move the allocation a little bit also. So we would take account of that as something. And so and then probably the, the other big component that we would think about is that we kind of like the idea of sort of making the baseline a little bit forward-looking. The idea of skating where the puck isn't, so to speak, or where the puck is going to be.

We know that the U.S. has a very high ratio of equity market cap relative to GDP and/or relative to population. Sort of any metric that you think of, and you start to look into the future, you can see that probably the U.S. equity market cap is going to become a smaller and smaller part of global market cap five years into the future, et cetera. So all those things we kind of put together and come up with our number. And then, as we say sort of towards the conclusion, once you come up with your number, then if you're going to be 5%, or even 10% away from that, it's not such a big deal.

We're talking about the case for extreme home bias. The 0% in international equities or the 5% or 10%, international equities, where we think you're really giving up a lot. But if you kind of come up and say, well, I think I should be 55% in the U.S. - in international equities. And then you said, I'm just going to be more comfortable making my baseline 45% in international equities, instead of 55%. You're not giving up that much to just move 5% or 10% away.

And so that's - so I think I think the important thing is to sort of come up with your baseline, think about how you've come up with it, and then stick to that over time. Don't revisit it and use a whole new different methodology based on what's been happening. So it's like, well, I did this five years ago, and geez, I would have been so much better off if I had had 15% more in U.S. equities. So now, I'm going to redo the process and add in a way where it adds 15% to my U.S. allocation. I think it's important.

The exact number isn't as important as sort of having a stable framework through time where you don't get pushed around and sort of wind up being a return chaser.

JL: Sure, return chaser. And also when you have the same numbers that you try to circle around regularly by let's say rebalancing even if it's just once a year, you're forced to sell your winners and buy.

VH: Yes.

JL: Yeah, load up on your losers. And that over time has almost always been a better performing strategy than just continuing to load up on stocks that have already performed really well on countries that have performed really well.

Okay, cool. Yeah, no, that's, that's great. And I think, good practical advice for listeners in terms of how to think of this properly. So I'd love to get into the specifics of your arguments here. Let's make the case for why extreme home bias or maybe even not extreme but too much home bias, let's say. So maybe even kind of 70-30 home bias when the market cap of your country's much lower than that, can be problematic and lead to worse returns over time.

You list 10 reasons in the article, you footnote them all really nicely and you debunk them one by one 10 reasons investors often favor home bias that you go through and show why they're not generally correct in that case. So I don't think we're going to go through all 10 of them, but I picked out most of them. And I'd love to just go through them and try to stress test them a little bit here and there.

The first item that you listed was U.S. equities have outperformed non-U.S. equities by 170% over the past 10 years. And preparing for this conversation. It's funny, I reread chapter five in William Bernstein's the Intelligent Asset Allocator, where he talks about allocating to international and international small cap in particular. And he has a similar argument that, over whatever when he wrote the book, and I guess, around 2000 or so, the U.S. had crushed international and it was the same kind of a well, why should I have to diversify, if the U.S. has crushed international equity so much over the last decade?

So clearly, there's been periods like this in the past. There will continue to be periods like this in the future. We do know there's such a thing as the momentum factor and that it generally works quite well. Why couldn't momentum be applied to country ownership leading to a current overweighting, significant overweighting of U.S. equities until their outperformance subsides?

VH: So that's what I - right at the beginning of our conversation, I was saying that this note is dealing with the idea of your baseline. So the idea of a momentum induced overweight of the U.S. market is fine. I mean, we believe in that too. I mean, we advocate that and incorporate that into our investing framework. But that's an overweight relative to your baseline. So to the extent that the U.S. has been outperforming over the last year or so, we believe that that's indicative of future outperformance as well until it stops. And then we wouldn't - we wouldn't have that momentum factor or that momentum signal calling for future outperformance.

And so we agree but it's a separate - that's getting into this sort of tactical overweight or underweight relative to your baseline. And so yes, I agree, but I think it's not, it doesn't mean that you should have a higher baseline weight because momentum is something that's going to come and go. And so you want to have your baseline from which you're then deciding on how you want to overweight or underweight.

JL: Sure. It's something that comes and goes. And it's also inherently backwards looking, in that it only talks about what's happened until this point. And so it's impossible to anticipate when momentum will shift and so that alone is a reason to not get too carried away with those kinds of rotations.

VH: Right, and not to build it into your long term. So the fact that you have positive momentum today doesn't mean that you should make your baseline be 90% U.S. equities. What's your process and unless - well, again, this idea that I think that is a useful systematic approach to investing to have your starting point, to have your baseline portfolio, and then to think about your adjustments relative to that, it's a really good discipline to approach the investing process that way.

JL: Sure. So moving over to the second item here, over the past 10 years an internationally diversified portfolio wasn't anywhere near optimal. If your models show that country or regions equities are, let's say significantly better valued. So one country is just incredibly undervalued, relative to its long term average. And so your outlook to there is very, very good. And then you see another country that just seems to be in really crazy, overbought territory. How far would you go, or can you go in terms of tamping down your allocation to something that really seems like it's poised to underperform relative to a country or region that seems like it's really poised to outperform?

VH: Well, again, we're in this discussion now of how to overweight or underweight the buckets. And the way that we do it is we do it basically in proportion to the cyclically adjusted earnings yield. So we're taking very broadly the case of, let's say that if our baseline allocation is 50% U.S. equities, 50% non-U.S. equities, just to take two really broad buckets, we actually break the world down into more than that. But if that's the case, and then the U.S. has an earnings yield of 4%, well, we kind of go into it saying that, we would like to see an earnings yield of around 6% to have our baseline allocation. That we like our baseline allocation, when the earnings yield on U.S. equities is 6%. Well, if it's 4%, we're just going to say, let's just have two-thirds as much as our baseline allocation.

Let's just be let's just move in proportion to this long term expected return indicator. And if it turns out that non-U.S. markets have a, say a 7.5% earnings yield, then we would say, let's have more of those. Maybe we'll have 15%, I don't know what is, 1.5 over 6 we will have 25% more non-U.S. equities than our baseline. So we just tend to think of it in proportion to the long term expected return signal coming from cyclically adjusted earnings.

We actually subtract out. We do it a little bit differently than that in practice, but there's another step where we subtract out the long term real rate coming from the tips market, but that's around zero right now. And so we have a bit of an adjustment for that, but basically, we're moving in proportion to the level of cyclically adjusted earnings yield we could say. So that's how we move it in proportion to this long term valuation metric or that's how much - that's how we overweight and underweight relative to baseline.

JL: Yeah. Okay, sure, I don't know if you wanted to get into specifics, but how are you viewing the U.S. in that regard relative to, let's say, developed ex-U.S. and then emerging markets also?

VH: Well, so at the moment in the portfolios in our client portfolios, when we look at the U.S. market, what we see is a market where there's the long term expected return isn't that great? I mean, it looks a little bit better relative to very low real interest rates. But still, it doesn't look that great. So from a long term valuation point of view, we're a little bit underweight relative to our baseline. U.S. equities, but then they have positive momentum. And so those two effects are almost exactly offsetting each other. And so for U.S. equities, our allocations are close to our baseline allocations. We're not significantly under or overweight.

With non-U.S. equities, it's a little bit case by case. But in general, away from Japan anyway, we see earnings yields as being quite high, offering attractive long term expected returns. So from that point of view, we're overweight. And we're overweight pretty much all the non-U.S. equity markets, developed and not developed, slightly with the exception of a small, the small, this relatively small global case of Japan.

And then from a momentum point of view, things are more mixed. Emerging markets are still displaying negative momentum. The UK has kind of flipped into positive momentum, I think. And so it's a little bit of a mixture depending on which markets we're looking at. And so overall, I think that we're probably - there's a little bit of an underweight coming from momentum, which is close to shifting to being more positive. So we're generally overweight, non-U.S. equities. Maybe we're 10% or so overweight, non-U.S. equities and we're at about our baseline on U.S. equities. And so overall, we're slightly overweight, equity exposure in aggregate.

JL: Okay, very interesting. And I'm happy you were able to get into some details there.

JL: Just kind of curious in terms of - and maybe we'll get into this more later, but how do you how does geopolitical risk factor into your models for expected returns here to take the case of the UK, for example. Obviously, expected returns on large segments of the UK economy are going to be affected by whether they have a soft or hard landing with Brexit. So they end up in a situation where all their trade deals are basically with Europe are just blown up overnight. I think that will, you know, obviously affect corporate earnings in the UK in a very significant way, whereas if they can get a deal through and keep things kind of the way they are, then the current projections would make sense.

So is there any way to really calculate for that, or is that kind of just a black swan type event hanging over all the calculations being done here.

VH: So in our approach, where we try to be very systematic and rules-based, we purposefully don't let our subjective assessment of what's happening in the world get into the signals and into the numbers. And that allows us to be more disciplined and it also allows us to charge 12 basis points for our services. It's really expensive to find people who are good at interpreting and reading the tea leaves and interpreting economic and political circumstances in the world and so.

JL: Expensive and pretty much impossible, right. I mean, that all the data about prognosticators show that they're not really, experts are not really any better at figuring out what's going to happen.

VH: We decided to go for inexpensive and systematic and to - and we knew - James and I knew that we ourselves are not very good at doing that. And we knew it'd be really expensive, and a lot of work to try to find people who could do a good job of that - even if we could find them. So we just don't really put that in. And I guess we do feel that it's our responsibility to stay up to date with what's happening in the world. So we do that and you never know.

It's hard to imagine but like if there were if we were about to see capital controls on the UK, I mean, if the UK was about to impose massive capital controls in high tech and full taxation of all dividends, we might say, okay, we need to adjust. We were looking at cyclically adjusted earnings yield for the UK. But maybe we need to look at sort of after tax dividends or something.

But those things are so far out. Again, we feel it's incumbent on us to follow what's going on. But it would have to be such a dramatic kind of regulatory regime shift for us to want to change what we're looking at for the asset allocation that could happen. But it's very unlikely.

JL: Yeah, sure. I think that's - it's well put and definitely interesting to hear your perspective there. And I guess the bottom line is if your crystal ball isn't working that day, or that year or ever, you may as well just control the things you can and everything will hopefully balance out over time.

Okay, so moving on to the next item here, investors favor the familiar. So at least in the case of individual stock picking. This is often touted famously by people like Peter Lynch invest in what you know, investors should go out, let's say somebody a - they work in Health Sciences. They may be should be tilting their portfolio, if they are stock pickers towards biotech and pharma and things that they're able to kind of sift between what may be good and what maybe is less good in a particular space.

In terms of international approach, why is that reasoning not relevant? So for example, why is it not relevant if I'm a U.S. investor, and I really just have no understanding of how the Chinese market operates, or how their economy is structured or any of those things?

VH: Well, I think that, at the end of the day, these publicly traded equity markets and corporations, they have earnings, they have dividends. There is a large degree of aggregation. And so a person might be more familiar with what are the - how do what the accounting regulations are in terms of reporting of earnings and dividends and so on within the United States relative to how those rules work in other parts of the world?

But I think it's kind of - I think that it's reasonable to believe that in all parts of the world where we have large public markets, and where a large amount of capital and international investability has become possible, that there's a pretty decent amount of transparency and standardization of reporting and so on that's taking place. And so I'm not saying that there's no difference between these different places. But I would say that, that investors kind of understand - that investors understand these differences in some sense and make for some differences in valuations between those markets.

So I think that coming back to the Peter Lynch comment, it's a really interesting question, right. I mean, like he was out there saying, I don't know. My wife came home with pantyhose and I was like, these are the best pantyhose I've ever seen in my life. These are awesome. I need to buy the Haynes Company as a result of that. And I made a fortune buying Haynes. Well, I think that was one of his stories. I forget. It was like that pantyhose that they were also changing where they're selling pantyhose or something.

The thing is that an individual, that the stock market as a whole - let's say the stock market as a whole might have like 15% annual standard deviation. Individual equities have a standard deviation of close to 30% on average. The individual equities tend to have twice as much annual standard deviation as the broad equity market.

So if you're going to go out there and try to buy individual stocks, you need to believe that you can identify stocks that are paying twice the return of the overall market in order to get the same risk return. Of course, if you own 10 stocks, you're starting to get some diversification. Although, the 10 stocks that you can know are probably going to have some similarities between them also. There are going to be very big stocks, are going to probably have some consumer side to them or whatever. And I just think that's an incredibly misguided approach to individual investing.

It might have worked, worked for him, and worked for Fidelity and worked for Magellan. But I don't think that a sensible...

JL: Sure, although he was obviously buying a lot more than 10 stocks and had a team of people poring through reams of data and doing research. Yeah no, I wasn't suggesting people to buying index funds and properly diversifying for stock picking. I was just more trying to touch on why that logic of invest, what you know which does seem to work for at least some disciplined investors, in the stock picking realm.

VH: Yeah, but the idea that the idea that anybody could really know, the U.S. stock market is - that what you know is these are the earnings. These are the dividends, I don't know, I don't think that there's such an enormous - I think that it's a bit of a fallacy to think that you really know the U.S. market, but that you don't know these other ones. I mean, I think that we're pretty much in the dark. We're quite in the dark, more than we'd like to think. And the idea of just being attracted to the familiar is a bias that can be really costly. And in fact as we talk about, right, that the more that - like if you're working at Morgan Stanley (NYSE:MS), and it's like, oh, you know, I'm really familiar with Morgan Stanley. I'm going to just invest in Morgan Stanley stock. I mean, what could be more misguided than that, right?

JL: That way, if the company goes under, you lose a job and your stock, like that also.

VH: Yeah,exactly. I mean, so that I think that familiarity thing is dangerous.

JL: Yeah, sure. No, I definitely buy that. Okay so moving over to the next argument here and I'd like to use this not to raise an additional question but just to kind of take a step back and go over some of the numbers and what the allocation to international equities over time has done for portfolios, both in terms of return and also lowering risk.

So the argument is, international equities don't offer much diversification because whenever U.S. equities experience a large correction, international equities usually go down as much or more, the usual a rising tide sinks all ships or what have you. So what is the data in terms of diversification versus overweighting your home country significantly in terms of, and obviously this depends on what the level of diversification is, but in terms of long-term returns, and perhaps even more importantly, in terms of achieving the same kinds of long-term returns with significantly less risk in your portfolio.

VH: Well, it really depends on, if we're going back over history, it really depends on what your home country is, right? So if your home country was Argentina or Russia, or China or Cyprus or Germany or Japan. You had some periods of time when your home bias was really expensive. If we're talking about the U.S. and we're talking about the last century of the U.S. experience, then home bias didn't really cost you anything materially at all.

And so you know, I think that the data - the data does show that the short term correlation that we're seeing is kind of an overstatement, relative to the longer term correlation that you would care about. But what we just can't really get from the data, and I think the most important part of international diversification is the fact that there are these tail risks within any given jurisdiction, that international diversification helps you to mitigate.

And it's just really, really hard to see that, you know, from the U.S. perspective, it's so hard to see that because of this very, very long period of incredible U.S. performance in every dimension. But we know that it's there. And we know that the U.S. situation is not by historical standards unique. So there's this tail risk that you can't - the data is not going to really tell you how valuable this tail risk diversification is, except to the extent that you look at these other countries where home bias would have been disastrous for local investors, but we kind of know it's there and it's a tail [ph] so it's a small probability.

Even having said that, though, there are these benefits to diversification even in relatively normal times over longer horizons as well. So it's not - it's not only about the tail risk, there is - that these different regions do march to different beats, especially once you start to look out at five and ten-year horizons. And that's what we tried to show here in this chart where we say, if you look at 10-year overlapping periods, the correlation between U.S. and non-U.S. markets drops to under 0.5, actually, even under 0.3 on our chart, whereas if you're looking at one month, you're looking at the correlation of one month returns, you're all the way up close to 0.8.

You know, one explanation for that is that equities are impacted by - you can think of equities as expected cash flows, discounted back at some discount rate that includes the risk premium. And so the numerator kind of moves around with more economic fundamentals, whereas the denominator is moving around with sort of the risk aversion of investors and so the discount rate can go up and down. And that tends to go across all markets and all equities, whereas the top part when that's moving around that's more - that's more diverse among different, but it takes a longer time for that to manifest itself in the real data. So a lot of the short term moves are kind of more in the discount rate.

And the longer-term moves are some combination of changes in the numerator and denominator of the cash flow discounting valuation of equities.

JL: Sure, yeah. And I think that because this generally takes longer to play out and particularly for U.S. investors, for them to see the benefits of being steadily committed to international allocation, requires a certain level of patience and belief that what's happened previously will continue to happen in terms of those benefits because it's not immediately obvious, markets generally react the same way in the short term, as you're saying, with enough periods of difference to really differentiate them over longer term horizons.

So I'd like to get over to move over to a specific argument you make here. Again, when you debunk, U.S. investors spend their savings in dollars, and so they should only invest in dollars to avoid the currency risk associated with non-U.S. equities. So first of all, if you could just again, explain why this line of thinking is not actually correct, but then I'd also be curious to get your take on, there's been a number of currency hedge versions of international equity funds that have rolled out over the last five to 10 years.

And I'm just curious if you allocate to these products at all, and if you do why, and if you don't what your reasoning is for notutilizing these products.

VH: So the first thing is we're kind of saying, well, the idea that my spending is in dollars and so I want my investments to be in dollars. There's an important truth in that. But what we're saying is that that really pertains primarily to that part of your portfolio, that's meant to be your minimum risk or your risk-free part of your portfolio. So…

JL: I was going to say, yeah, if you're in the U.S. don’t buy a Japanese money market fund, for example.

VH: Yeah, right, exactly. So you don't want to have a yen based money market fund or you don't want to be long JGBs currency unhedged. You know, you sort of want to be in U.S. government bonds to against your basic spending needs. And then you have, that part of your portfolio that's invested in risky - is the risky portfolio, the risky part of your portfolio where you're taking risk, with the promise of a positive expected return.

And what we say as well, it really doesn't matter that once you are into the risky part of your portfolio, where you're trying to earn a return for bearing risk, all you care about is the return and the risk, you don't care about where it's coming from, whether it's coming from - whether that risk is, is coming from the risk of international trade being bigger or smaller, or if it's coming from the risk of innovation in battery storage, or whatever the risk, whatever those risks are, you're sort of taking all of these risks to try to earn a return. And so if it's coming from currency risk or other kinds of risk that you shouldn't - that doesn't really need to get differentiated out and say, no, I just don't, I don't want to have any of the currency risk.

Now there's questions about, you know, whether you're getting compensated for the risk, for taking the currency risk or not, and how big is currency risk within the variability of owning non-U.S. equities. And we go into that a little bit, especially in the footnotes and we're pretty comfortable that the simplicity of owning non U.S. equities without the currency hedge warrants doing it that way. And we're not convinced that currency hedged equity holdings are lower risk, then - or have a better - we should say, or have a better risk return, then owning international equities, non-currency hedged.

And one of the things that really bugs me, or two things that really bug me about these currency hedged products are one is, that they tend to be really expensive. I mean, not only are the expense ratios higher, but there's sort of non-transparent transactions costs that are embedded into this thing.

JL: I was going to say, yeah, they're rolling over futures every month. There's some underlying cost that's buried beneath the expense ratio.

VH: I don't even think they're doing futures, right. They're generally doing over the counter or non-transparent derivatives with banks.

JL: They're using swaps, which is okay, so even possibly costlier. Yeah.

VH: Yeah, I mean, completely non-transparent. The other thing is right, that you can actually lose - it would take a big move, but you can lose all - you can lose more than 100%. I mean, it's limited liability, but you can lose 100% of your money in a currency hedged vehicle, right. So you're kind of sitting there and you're long - I don't know - you're long this hard to imagine these big moves, but you're long the British, you're long, UK stocks and its currency hedged. And now all of a sudden your stocks go down, 40% and the currency - and at the same time, the currency goes, let's say you're going to be short the currency and so the currency goes up by 40%. And before anything happens, you just have lost like 100% of your money.

So right because you're long £100 worth of UK equities. And now there's a currency forward against it where you're short £100 and long $100 in this currency trade. And so the equities go down a lot. And but at the same time the pound goes up a lot, which you are short, and you actually are fully wiped out, you could get wiped - you could actually - the fund itself could actually lose more than 100% of its value. There's like an effective leverage in that transaction which cannot happen to you if you're just long it outright.

JL: Right, yeah, I mean, I think their funds are structured so that the currency exposure is supposed to be somewhat limited, but I mean, what I've heard advocated but again it's never made sense to me with the actual expenses when you get done with it is that it's not that you load up on the currency hedge, British pound or euro or Japanese yen, equity fund, it's that to eliminate currency risk, you would split your allocation 50-50.

So half of your allocation would be to, let's say a STOXX 50 fund that was held in dollars, and the other 50% of it would be in STOXX 50 fund, that was hedged to the euro instead, and that way you eliminate the currency risk entirely, because it's a total wash. But again, I tend to agree with you that the expenses of the entire enterprise would seem to make this a non-starter for most people.

VH: Yeah, expenses complexity. Yeah. So and as we point out in the note, I mean, there's actually times when it's nice to have - again, it's hard for U.S. people to imagine this or to see it, but there's like if you're a British investor over the last couple of years being diversified away from your home currency is nice that's - that was nice. And in general, again, you've got all of your sort of low risk investments in pounds. It's okay to have some other currencies of the world. It's alright to be spread out like that. That's diversification.

JL: Yeah, sure. No question about it. Okay, so I'd like to move over, you mentioned inexpensive and I think many listeners of this show will be aware of the fact that because of ETFs in particular, but I think just because of globalization and the fact that the world is smaller and brokerage fees are much lower, and there's a million reasons at this point, investing in non-U.S. equities is not really all that difficult and expensive anymore, even though that was kind of the perception and thetruth I think even a generation ago.

So I buck [ph] you to - just for people that are not fully aware, you point out in the piece, just how much that gap has closed there, what are typical expense ratios like at this point on foreign exposure and is the additional expense ratio any reason at all for some kind of slight home bias or is it so meaningless at this point as to not even be worth considering?

VH: Yeah, so I mean, exposure to non-U.S. equities now from the point of view of a U.S. investor, you can get total international marketplaces available at an expense ratio of eight or nine basis points from Vanguard and iShares and Schwab and others. Within that they're doing some stock lending. So, the net expense ratio is even a little bit lower than that. But there are some - the first of all, that is higher…

JL: Is that - sorry, just to interrupt, sorry, Is Vanguard doing stock lending, I know other companies do. I was pretty certain that they actually don't do any stock lending. That's one.

VH: No, no, they definitely do. They do. And I think the difference is that Vanguard has always been committed to kind of sending a 100% of the stock lending revenue back to the investor. And there was some controversy when some of the other investment managers in particular, BlackRock (NYSE:BLK) was not sending 100% back, although I think they're a lot closer to 100% now, there was a bit of investor pushback on that.

JL: Got you. So it was showing up in their earnings as opposed to in returns.

VH: Yeah, and Vanguard doesn't make a big deal of it, like other places like DFA have made a big deal of it. You know, Vanguard doesn't - and Vanguard is kind of conservative about the lending that they do. So maybe they lend less than what some other players - how much other players are lending out, and they have some concentration limits on who they lend to, or whatever. But no, they are lending in all of their things. I just recently was reading their prospectuses and writing down, we were going to do a piece on how much lending revenue there is in these Vanguard funds and it was easy to find in their prospectus.

JL: Nice. So I'd love to see that.

VH: Yeah, it's and it's - I mean, in this world of people caring about whether an index fund has a three basis point expense ratio or a six basis point expense ratio, there's several basis points of lending fees that are there. And there's also, I mean, not so much at this moment in time, but following financial disturbances that these index funds also make these litigation recoveries.

So if Enron or that there were lawsuits following the collapse of Enron or WorldCom or these different companies, and shareholders wind up being entitled to compensation through these class action suits and some of that - that compensation as long as the mutual fund claims it, comes back to the mutual fund and over a whole cycle of investing, that's also a material incremental return for investors to following '08, '09, these litigation recoveries from index funds at Vanguard were substantial. It was to the benefit of anybody who was actually an investor afterwards even though - even if you weren't invested in '08, '09, you got the benefit of them if you were an investor in 2011, for instance.

So anyway, I mean, I think top level all this stuff doesn't really matter very much. Can it - as we say could move your allocation low-single digit percentages, but you could ignore it. And not be any worse off. I mean, things have come so far. I mean, it's amazing to think that until the early 90s, you couldn't really invest internationally and those Vanguard funds when they came out were at 50 basis point expense ratio. So home buyers really made a lot of sense back in their early 90s or earlier for individual investors.

But today, it's just, it's - everything is just so much better, that there's no reason to not avail oneself of it.

JL: Makes a lot of sense. So I'd love to get into - before we go here, if we could talk specific ETFs that you're using in your practice, both for your clients or for yourself, or listeners, like specific names to be able to go out and research and obviously there's just so many alternatives available to U.S. investors at this point in the international equity space. We're talking about literally hundreds of different funds that offer different slices indices.

So I guess for starters, how tactical are you getting, are you just buying for most portfolios, a few broad funds or are you actually going out and saying, okay, I want to buy 20 different single country funds. I'm sure you're not doing this, but just curious in terms of how much you're calibrating that.

VH: Right. So we're not doing that. We sort of thought about it and searched for what's the right level of granularity, which is kind of a somewhat subjective sort of decision, but it's also driven by costs because if you did want to go the single country fund sort of route, that's like a - that turns out to be a 50, 60 basis point average expense ratio for non-U.S. products, compared to say, we're going to do Europe, developed Asia and emerging markets, and take those as my non-U.S. buckets. You have to throw in Canada because otherwise Canada gets left out. But we won't mention Canada again.

JL: Right. Having there are indexes that include Canada, but the standard EAFE indexes do not, I don't believe.

VH: Right. So if you - but so however you want to do - so if you break, so you could just go for like, VXUS, which is all the U.S. - sorry, all non-U.S., including Canada, and that's a really good for an individual investor. That's - then you're kind of into this. I've got U.S. equities, I've got non-U.S. equities. Maybe you want some REITS or something like that. But more or less, that's the risky part of your portfolio.

JL: Sure. And that's just for people that are curious. That's the Vanguard Total international stock ETF and again, as you said, that one holds U.S. and ex-U.S. its market cap weighted index, I believe, correct?

VH: Yes, sorry, VXUS only owns non-U.S. VT is the one that owns everything in the world that…

JL: Everything, total world. Yeah, sorry, okay. So VXUS is - got you.

VH: Yeah, VT is total world and VXUS is total international. We like the level of granularity that we like is VGK for Europe, is VPL for developed Asia and then VWO for emerging markets but equally we really like the iShares equivalents of those which are called the core - is their core offering which they brought out more recently and their emerging market one is IEMG. Their European one I think is IEUR, what's their Asian developed one.

JL: I'll pull it up right now while you're talking.

VH: So the iShares core offerings are great. They have big, they go all the way down to small caps from large caps, very low expense ratios, that those are the iShares ETFs that were the response to Vanguard getting more market share. I mean interestingly iShares didn't discontinue their EEM ETF, which I would recommend nobody buy. But they said, okay, we're going to just continue to let anybody who wants to pay 50 basis points and be in EEM that’s about the expense ratio rather than bring the expense ratio…

JL: Yeah, might even might even be more I think.

VH: Yeah,maybe. So instead of bringing EEMs expense ratio down, we're just going to - for people who want a low cost we're going to create this IEMG. And that's been great, that's been a great success and we use it and we love it.

And there's some other products out there, that the JPMorgan (NYSE:JPM) has started to create some ETFs to fill in some of the spaces, that other providers didn't want to compete on so, for instance, for a high yield ETF, rather than use the iShares or State Street one, there's a JPMorgan one that’s much less expensive. So there's other choices but I would say that mostour portfolios are - most of our client portfolios for U.S. investors anyway are primarily using Vanguard and iShares low cost products.

JL: Sure, the ticker on their Asia one by the way is IPAC. Is that the one you were thinking about right, iShares core MSCI Pacific.

VH: Yes, exactly, exactly. And we tend to break the world up into - for our client portfolios, as we tend to break the world up into about 10 buckets, so U.S. broad equities, Asia and European developed equities, EM Canada, that's five, Real Estate Investment Trust is six. Then we have Tips, we have - for taxable investors, we have a Muni bucket, we have a small high yield bucket. So it adds up to about 10 buckets in total is how we slice the world up. And then think about overweighting or under weighting, our baseline allocation to those different buckets. And we have in the U.S., we still have a small allocation to small caps and to low price to book companies as well, just because the U.S. is such a big allocation to begin with.

So that's kind of more or less what our client portfolios look like.

JL: Sure. And you had mentioned earlier that you were underweighting Japan. So are you using an ex-Japan fund on top of a fund like IPAC to do that or how are you executing that exactly?

VH: No, no. Well, I wasn't really saying yeah - I guess I wasn't - we have a couple of different products where sometimes we break out Japan, but for our main products that we do, our main portfolio that we're doing at Fidelity, we actually have Japan lumped in with developed Asia. And we're just using that IPAC, or the VPL ETFs to cover the whole thing. And then the valuation and momentum of Japan get blended in with the rest of developed Asia. I mean Japan is probably about half of developed Asia altogether. So it has a big impact, but for probably half of the portfolio is we manage, we have Japan, blocked in with the rest of developed Asia.

JL: Sure. And then any final specific question here, any exposure to frontier markets or not necessarily at this time?

VH: No, no, we don't. I mean, whatever the, to whatever extent the frontier markets are included in the broad emerging market indexes, we pick that up, but we don't have a separate allocation to them. We think it's - we think that they're too small to warrant a separate allocation and too expensive as well.

JL: All right. Anyway, Victor, this has been really illuminating. It's been really interesting, lot of broad kind of topics that we covered here, but also a lot of specifics for people to chew over and go back, look at some of these funds. And I think you're obviously tactically allocating. You said you had 10 different buckets, but I think for many investors, just taking a couple of these really broad funds like the Vanguard or the iShares ones, probably sufficient. So if you just have your U.S. and your ex-U.S. developed and emerging or even just some kind of an all world fund that really could be all you need in terms of equity exposure without giving advice to anybody specific here but I mean I think that probably we do it for most people.

VH: Yeah, there's so much value in keeping things simple when you're doing it yourself. It's really - can't be overstated how important it is to keep things really simple.

JL: Yeah, no, definitely. Anyway, this has been really great. Just wanted to let people know how they can find you online or on social media in case they want to get in touch or reach out to you, do further research.

VH: Sure. You know, our website is Elmfunds.com ELMFUNDS.com.If you search for my name, I think Elm Funds comes up also, Victor Haghani. And my email address is victor@elmfunds.com. So, yeah, thank you so much, Jonathan. I really enjoyed it. And you know, I learn a lot through the process of discussing this every time. So I really do appreciate the opportunity to spend some time discussing this with you and your listeners.

JL: Yeah, absolutely. No, this has been great and I feel the same way, the whole process, first of all, just of reading your articles and looking at some of the comments on them. And there was one interesting one that we didn't touch on, but which was just about looking at kind of how democratic specific countries markets are. So maybe for another day, something we can get into.

Anyway, keep up the great work. I'm looking forward to your next piece.

VH: Oh, thanks very much, Jonathan.

Disclosure: I am/we are long VXUS, VT, VGK, VPL, VWO, IEMG, IPAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: For disclosures, Victor Haghani invests most of his personal money with Elm Partners, using the same strategies he uses for his clients.

Victor is long - either for himself, his clients or both - the following ETFs mentioned in today’s show: VXUS, VT, VGK, VPL, VWO, IEMG, IEUR, and IPAC

Jonathan Liss is long IEMG and VWO