One of the biggest themes in the market right now is the migration from U.S. to international stocks, namely European equities as they present better relative value than their U.S. counterparts.
Looking at a chart of popular European equity exchange-traded funds, you might think how could that be? They haven’t performed that well at all. Yet, upon second look and backing out the currency relationship between the U.S. dollar and euro, it becomes clear that the European Central Bank’s commitment to stimulus and growth has goosed prices.
To add credence to this migration is the endorsement of several prominent economists, my favorite being Robert Shiller, the Nobel Prize winning professor and co-founder of the CAPE methodology for asset valuation. Shiller has proclaimed that he is now reallocating a large sum of his personal portfolio abroad as a result this relative value relationship between U.S. and European stocks.
So, as a retirement income investor, do you follow the herd in search of new opportunities or remain steadfast with your traditional dividend-equity approach?
In my opinion, investors should remain steadfast with U.S. allocations, primarily because of the relationship that retirement investors have with their assets. To put it plainly, they need them to provide a reliable income stream and support their lifestyle. Furthermore, I haven’t met a retiree to date that isn’t concerned about volatility.
Once you begin layering currency dynamics and foreign economies that you might not fully understand into your investment process, the complexities become more difficult. Especially in light of the fact that European stocks exhibit a much higher beta or measure of volatility over a full market cycle than U.S. equities do. Retirement income investors simply don’t need to assume the level of risk that a fund such as the Vanguard FTSE European ETF‘s (NYSEARCA:VGK) -0.11% offers.
Look at it this way; if you bought VGK two months ago before the majority of the aforementioned up-move unfolded, you got the region and theme right. However, your returns were paltry in light of the fact you owned European equities in the wrong currency. You would have needed to own a fund such as the WisdomTree Hedged International ETF (NYSEARCA:HEDJ), +0.02% to yield the result that pundits are raving about.
It’s my belief that investors shouldn’t use currency hedged international products unless they are closely following the underlying currency in addition to the underlying foreign market dynamic. Even then, they should have a strategic plan laid out to react to future fluctuations in both.
I come from the old school belief that the entire point of owning international equities is to diversify outside the U.S. dollar and the U.S. economy. Up until recently, investors would have to own an exchange-traded fund such as VGK and hedge the currency exposure themselves through derivative instruments to gain the advantage that HEDJ offers.
Unless you were a sophisticated enough investor to implement a strategy like that on your own before, what makes you qualified now?
Another interesting question you have to ask yourself if you decide to migrate to foreign equities is how you’re going to benchmark your returns. Nearly every retirement investor I’ve ever worked with has always benchmarked their returns relative to the U.S. stock and bond market.
By shifting a large sum of your portfolio to international stocks, it opens us the real possibility that you may underperform U.S. stocks in a meaningful way sometime in the future. You simply need to ask yourself if you’re comfortable with that type of outcome considering the volatility international stocks experienced in 2008 and 2011.
I do believe that a balanced income portfolio can benefit from a broadly diversified international dividend equity ETF such as the iShares International Dividend Index (ETF) (NYSEARCA:IDV), -0.31% or the WisdomTree International Large Cap Dividend ETF (NYSEARCA:DOL), -0.12%Especially when comparing yield numbers with domestic counterparts such as the iShares Select Dividend ETF (NYSEARCA:DVY), -0.85%
My biggest fear is investors that are merely tuning into these themes now in hopes of chasing recent performance and as a result entering into investment vehicles in the latter stages of the trend. For Investors in our Strategic Income Portfolio, we have our international dividend exposure capped at 5% of the total portfolio, which is reasonable in light of the volatility and risk.
My advice for retirees that are considering a large-scale migration is to err on the side of caution and prudence.
Disclosure: Clients of FMD Capital own shares of the iShares International Dividend Index ETF.