Friday, November 17, 2006

Is the Time Still Right for Foreign Bond Funds?

Is the Time Still Right for Foreign Bond Funds? - New York Times
(Another hat-tip to the Kirk Report)

One thing many long-term investors are still doing is missing a good way to add some degree of currency diversification to the bond component of their portfolios. Foreign bond diversification. Roger Gibson, in his wonderful book on asset allocation, titled, um, Asset Allocation, Balancing Financial Risk, 3rd Edition, Mcgraw-Hill, 2000, presented some fascinating information about the inclusion of some foreign bonds in your bond allocation: a strong possibility of both improved performance and reduced overall portfolio volatility over most five-year holding periods. Almost the proverbial "free lunch" that we all were taught early on just does not really exist. This is the nearest thing to a free lunch you may see. And frankly, long-term heavy pressures on the dollar will be working to deliver some benefit from a measured exposure to unhedged foreign bonds

Gibson argues for an unhedged foreign bond approach. Dimensional Funds, not an outfit you can easily go against, prefers a hedged approach. I like Gibson's reasoning -- at least I think his arguments have yet to be clearly rebutted by anything I have seen. For those wanting more on this, the "Vanguard Diehards" forum at Morningstar.com has some good threads which you can search out. You can read the forums free. In fact, Morningstar has a lot of free content. Just don't start obsessing over star ratings.

Anyway, the idea is great; the difficulty is in the implementation. The preferable vehicle, an unhedged foreign developed-markets indexed bond fund with low expenses is just not yet readily available to smaller investors to this point. There are hedged funds, and some actively-managed unhedged mutual funds exist, and I have a working choice I use, but you get the usual pretty high expenses with those. ETFs may be coming into the picture, see below. And of course, just as the article says, this asset class really should only be placed in a tax-deferred account, like an IRA or 401(k). These are taxable bonds. beacause of all these factors use of this asset class -- foreign bonds -- is a judgement call, even for an investment professional, who must weigh client-specific risk and volatility tolerances as well as all the above. As usual, professional advice should be sought if you have serious doubt about the utility of this kind of fund for your own situation, or do not understand the issues involved.

As an additional note, there may be developments in this asset class in the world of ETFs. I'm a bit careful with new ETFs myself, though, and like to see some significant trading volume and tracking error history first, before I get serious about using them, for any number of reasons. And I know I'm not the only one who feels that way.

Bye from the Unknown Advisor for now.

Finally, as with just about anything else you will see discussed in this blog, we are specifically limiting our discussions to long-term investing. Only. That means a multi-year holding period, say, optimally five years or longer. Trading-oriented folks, please get a grip. Stick with what works best for your approach!

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