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Evaluating the Vanguard International High Dividend Yield Index Fund

Quick housekeeping note: My wife and I are in the middle of a move from Colorado to St. Louis. As a result of that and a minor medical issue (nothing to worry about, but it’s taking up a fair bit of time), there will be no articles until Monday 11/7, at which point the publishing schedule will resume as normal.

A reader writes in, asking:

“Have you looked at the new international high dividend yield index fund that Vanguard released earlier this year? I think it looks appealing, but it’s new so hardly has any track record. I’d be interested to hear your thoughts.”

With regard to dividend strategies in general, there’s no economic advantage to receiving dividends rather than an equal amount of price appreciation. (And in fact, there’s a disadvantage, if the fund is held in a taxable account because the dividends will be taxed immediately whereas capital gains tax isn’t incurred until holdings are sold. And capital gains tax can sometimes be avoided completely if the holdings are left to heirs.)

So a dividend strategy is only useful if there’s some reason to think that dividend stocks will outperform other stocks of similar risk.

Overweighting high-dividend stocks relative to their market weight often results in a portfolio that is heavy on value stocks — because value stocks tend to have higher than average dividends.* And both Vanguard and Morningstar do classify the new Vanguard International High Dividend Yield Index Fund as an international “large value” fund.

So how does the new fund compare to Vanguard’s existing foreign large value fund (i.e., the Vanguard International Value Fund)? The following chart (made with the Morningstar website) shows how the two have performed since the inception date of the new fund. The blue line is the new International High Dividend Yield Index Fund, and the orange line is the older International Value Fund.

international-dividend

As you can see, they have tracked each other very closely.

As far as differences, the new fund does have a slightly lower expense ratio (0.30% for Admiral shares, as opposed to 0.46% for the International Value Fund), which is certainly a good thing.

And, unlike the existing actively managed fund, there’s no possibility that the new dividend index fund will experience outperformance or underperformance due to good/bad individual stock selection. Personally, I see that as a good thing. But others may disagree if they’re more optimistic about the value of low-cost active management.

In other words, if you’re looking for an international large-cap value fund to add to your portfolio, the new Vanguard International High Dividend Yield Index Fund looks like a perfectly good choice. I would not say, however, that it is anything particularly groundbreaking compared to Vanguard’s older offerings.

*Brief tangent: I recently encountered this article by Rick Ferri, which does a great job explaining why the value premium may be directly tied to dividends.

Why Is Currency Risk Bad?

A reader writes in, asking:

“I don’t see why currency risk is necessarily bad. Sure, sometimes the dollar will increase in value, making your foreign investments worth less. But sometimes the opposite will happen. It seems like, on net, this should neither help nor hurt over an extended period.”

As a bit of background information: “Currency risk” refers to the volatility that foreign investments (such as international stock funds) experience as a result of fluctuating exchange rates. For example, your international holdings will decline in value if the dollar increases in value relative to the currencies in which your foreign holdings are denominated. Currency risk is often cited as a reason for underweighting international stocks and bonds relative to the part of the overall world market that they make up.

This reader is correct that currency risk should, on average, neither increase nor decrease your returns. And that’s precisely why it’s an undesirable risk. After all, there are an assortment of risks that do increase the expected return of your portfolio: increasing your equity allocation, increasing the duration of your bond holdings, reducing the average credit rating of your bond holdings, etc.

So, if there’s a certain level of overall risk that you can tolerate, you might as well get as much expected return for that level of risk as you can. In other words, why take on any risks for which you would not expect to be compensated? (This is also, by the way, the reason that holding a concentrated portfolio of individual stocks does not typically make sense. It increases the risk relative to a diversified stock portfolio, yet it does not increase expected return.)

To be clear, the point here isn’t that including an international allocation is a bad idea. It isn’t. Most experts agree that including international stocks in your portfolio is still desirable, because it increases the total number of stocks that you hold, which improves diversification, and because it adds a component that has less-than-perfect correlation to U.S. stocks while still having similar expected returns. The point is simply that it likely makes sense to hold a smaller allocation to international stocks (and bonds) than you would if currency risk did not exist.

Why Do Risk-Adjusted Returns Matter?

A reader writes in, asking:

“Why do academics always talk about risk adjusted returns? I get that risk matters and you shouldn’t have a riskier portfolio than you can manage. But if I compare two strategies over a period, I’m better off at the end if I used the strategy with the higher return, not the one with the higher risk adjusted return. So why is risk adjusted return relevant?”

The usefulness of the risk-adjusted return concept is that we can use it to evaluate a proposed strategy to determine whether it has historically been a better way to increase returns (or reduce risk) than simply adjusting any of several other well known variables (e.g., stock vs. bond allocation, duration of bond holdings, credit quality of bond holdings, etc.).

For example, imagine that you currently have a 50% stock, 50% bond portfolio that uses simple “total market” index funds for both the stock and bond portions. But then you meet with a financial advisor who suggests that you would be better off if you got rid of your total market stock funds and switched to a portfolio of individual stocks, picked according to a specific set of criteria. And this advisor shows you historical data demonstrating that his hand-picked stock portfolio has had higher returns over the last several years than your total market stock funds.

Obviously, one problem here is the critically dubious implication that the past is a good predictor of the future. But let’s set that aside for the moment to focus on another problem: A portfolio comprised of a handful of individual stocks will generally have far more risk than a broadly diversified total market stock portfolio.

In other words, the advisor isn’t making an apples-to-apples comparison, and he has not demonstrated that his strategy is actually an improvement over a total market strategy. What needs to be demonstrated is whether the 50% bond, 50% hand-picked-stock portfolio the advisor is proposing has had greater returns than an index fund portfolio with the same level of risk.

For example, you might find that the advisor’s 50/50 strategy with handpicked stocks has historically had a risk profile comparable to a 70/30 stock/bond portfolio using total market funds but that its historical annualized return is closer to that of a 60/40 portfolio using total market funds. If that’s the case, then the advisor has clearly not added any value. All he has done is bump up the risk and return in an inefficient way. A 70/30 total market portfolio would have had higher returns with the same level of risk as what the advisor is proposing, and a 60/40 total market portfolio would have had the same level of returns, with less risk than what the advisor is proposing.

When Does a 100%-Stock Portfolio Make Sense?

Administrative note: I’m thrilled to be back to working on articles after an enjoyable and productive break. At the same time, having had two weeks to reflect on it, I’ve decided to change the schedule to just two articles per week — basically the same as for the last few years, minus the Wednesday article. The point of the change is to free up more time to work on updating existing books and creating new ones — something that I haven’t been able to spend a sufficient amount of time on so far in 2013, as readership (and therefore volume of reader emails) has increased.

A reader writes in, asking:

“I recently inherited nearly $200,000. I’m 25 and am new to investing, but I’m reading everything I can to make sure I don’t squander this opportunity by investing it poorly. Based on what I’ve read, because I’m young and because I now have plenty of ‘cushion’ I can use a risky asset allocation. Is there any reason I shouldn’t go 100% in stocks?”

An all-stock allocation can make sense in the right circumstances:

  1. You want to take on lots of risk in the hope of higher returns,
  2. You can afford a large decline in the market, even if that decline is not followed by an immediate comeback, and
  3. You have good evidence that you won’t panic and sell during a sharp market decline (or, the size of your retirement portfolio relative to your total economic assets is small enough that it’s no big deal if you do end up panicking and selling at the bottom of a bear market).

Stated differently, you must want to have a high-risk portfolio and you must have the economic and emotional risk tolerance to handle such a thing.

In addition to being able to satisfy requirements #1 and #2, many young investors can satisfy requirement #3 because their portfolios are small enough that even if they do capitulate and sell during the next bear market, it’s no big deal for their long-term financial success. They (permanently) lose a little money, but in the process they gain valuable information about their risk tolerance — not a wholly bad experience.

But for anybody with a significant amount of assets on the line, it doesn’t make sense to use a high-risk allocation unless you have evidence that you can handle such a level of risk. And the only way to have such evidence is to have actually made it through a real-life bear market without selling. (And this is why, if I were in the above reader’s shoes, I would not personally want to have an all-stock portfolio.)

Further, for that previous bear market experience to be particularly meaningful, it must have been under economic circumstances that are at least roughly similar to your current circumstances. In other words, if your portfolio is now many-times larger than it was before the last bear market or if you’re now retired whereas you were still working during the last bear market, knowing that you didn’t panic and sell last time doesn’t necessarily tell you very much about what you’ll do this time.

What to Do with a Lump Sum?

A reader writes in, asking:

“I have about $200,000 of cash that I’m looking to deploy. I have settled on the “coffeehouse” allocation a la Bill Schultheis. [Mike’s note: See here.] But I am weighing the pros and cons of getting in at once or in increments over time.”

This is one of those classic investing questions that get asked over and over. Fortunately, there’s no shortage of research addressing the topic.

For example, a Vanguard study from 2012 used historical returns in the U.S., the U.K., and Australia to compare the results of dollar-cost averaging (that is, spreading out the investment over time) as opposed to lump-sum investing. The conclusion: Relative to investing the money all at once, dollar-cost averaging typically results in lower returns and lower risk.

And that outcome is precisely what we would expect, given that (relative to investing the money all at once) dollar-cost averaging results in a higher average allocation to cash and a lower average allocation to stocks over the period. In other words, dollar-cost averaging (as an alternative to lump-sum investing) doesn’t achieve anything magical. It just slows down the rate at which you move from cash into your targeted asset allocation.

And therein lies the problem with spreading out the investment over time. If you really do think your targeted asset allocation will be a good fit for you several months from now, why wouldn’t it be a good fit right now as well?

Is Your Target Allocation a Good Fit?

Before making big changes to your asset allocation (i.e., by moving out of cash and into stocks and bonds) it’s important to do some thinking about your risk tolerance.

For example, if the lump sum of cash is the result of an inheritance that dramatically increased the size of your overall portfolio, there’s a good chance that your risk tolerance is different from what it was prior to receiving the inheritance.

Or, if the reason you have a pile of cash sitting around is that you sold all your stock holdings at the beginning of 2009 and it’s taken four calendar years of positive returns for you to start thinking about getting back into the market, then you probably have a fairly low risk tolerance — much too low for the allocation that you held prior to getting out of the market.

In other words, if you’re experiencing significant hesitation about moving into your desired asset allocation, you should consider the possibility that that’s a sign that the allocation you have planned to use is not actually a good fit for you.

In that way, dollar-cost averaging actually can be useful for testing out your target asset allocation. Implement it with a piece of your portfolio and see how it feels. Of course, ideally, the test should encompass both a bull market and a bear market — and that would likely take several years. Still, if you’re experiencing anxiety about making the change, even a brief test may be preferable to no test.

How (and Why) to Assess Your Economic Risk Tolerance

Last week we talked about assessing your emotional risk tolerance. Today let’s talk a bit about assessing your economic risk tolerance and how to put that information to use.

When assessing your economic risk tolerance, there are several factors to consider. For example:

  • If you are not yet retired, how secure is your job (and your spouse’s job, if applicable)?
  • Do you have any large, uninsured risks (e.g., you’re self-employed and have no disability insurance)?
  • What percentage of your monthly expenses are (or will be) covered by a pension, lifetime annuity, or Social Security?
  • How large is your emergency fund (as measured in months of expenses)?
  • Do you have any debt?
  • If you are retired, how easily could you go back to work? And how willing would you be to do so?
  • If you had to, by what percentage could you immediately cut your monthly expenses?
  • If you had to, by what percentage could you cut your monthly expenses within the next several months (e.g., you rent and could not move tomorrow, but with three months of warning, you could move to a less expensive apartment)?
  • If you are not yet retired, how flexible are you with regard to your desired retirement age?

Putting Your Risk Tolerance Assessment to Use

In the accumulation stage, your economic risk tolerance is used in conjunction with your emotional risk tolerance to determine your asset allocation. This can be done as one combined process (see this worksheet from CFP Dylan Ross as one good example), or it can be looked at as two separate questions:

  • What is the highest stock allocation that your economic risk tolerance would allow?
  • What is the highest stock allocation that your emotional risk tolerance would allow?

…with your stock allocation ultimately being set to the lower of those two limits.

In retirement, your economic risk tolerance is still important for answering the asset allocation question, but it’s also used to answer two additional questions:

  1. How much of your portfolio will you annuitize?
  2. How much will you spend from (the non-annuitized portion of) your portfolio per year?

You see, in retirement, you can only reduce risk so far via asset allocation choices. If you have a very low risk tolerance (that is, you’re particularly concerned about running out of money), the highest-impact thing you can do is not to move more of your portfolio to bonds (which would still leave you exposed to longevity risk), but rather to annuitize more of your portfolio (thereby providing you with a source of lifetime income) — or simply spend less from your portfolio each year.

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