Go global instead of slicing & dicing your stocks by region

In a recent article, Globe and Mail columnist Rob Carrick tackled the important issue of global stock diversification.  He surveyed several investment advisors and portfolio managers for their recommended allocations between Canadian and non-Canadian stocks.  Carrick makes many good points – e.g., reminding readers of past investor mis-behaviours and how current fund flows could be repeating those past mistakes.  But I was surprised at the experts’ suggestions.

To be fair asset allocation across and within asset classes is very much a blend of art and science.  But I expected at least one expert to avoid the typical Canada, U.S. and International stand-alone slices for stock exposure.  Splitting stocks between Canada and global mandates (with developed and emerging markets included in global) makes the most sense to me regardless of whether you’re an advocate of indexing or active management.

Indexing disciples should follow Carrick’s idea of simply allocating 4% of your stocks to Canada to reflect our share of global stock markets by current market value.  This is the truest form of the theory underlying indexing.  Funds like Vanguard’s Total World Stock Market ETF (VT/NYSEArca) include the entire world – i.e. Canada and the rest of the world; developed and emerging markets – making it a great cheap once-decision fund to cover the world’s stocks.

(A similar Vanguard ETF excluding Canada trades on the TSX which may be preferable when paired with Canadian exposure for wealthy individuals and for TFSA accounts.)

This approach can be more tax-efficient – e.g., realized losses on emerging markets stocks are offset by gains in U.S. stocks – and can help avoid the many pitfalls of buying narrow slices of financial markets.  I’ve seen countless examples of investors using ETFs because of the appeal of indexing – only to end up making active bets and paying the price in the form of poor performance.  Besides, if you buy into the theory of indexing you have no basis for believing that your active bets can add value.

Advocates of active management should also favour global funds rather than slicing up the world using country and regional funds.  If you choose an active manager, you should want the skilled manager to have more flexibility – not less.  In other words, the best mandate is a global mandate that includes emerging markets and is not tied down by any other rigid constraints.

Sure you might have to take a pass on your favourite U.S. or European manager because they lack global specialty.  But advisors and investors are too prone to making the wrong active bets on this country or that region.  Deciding on the geographic make-up of your non-Canadian stocks is better left to a skilled global manager than the end investor or financial advisor.  I include my self and our firm in that statement.

Astute readers might recall that I was asked how I planned to invest my annual TFSA contribution in early 2012 .  My reply:  divide it between a U.S. ETF and an overseas stock fund.  But as I explained in a related blog post, blending active and passive approaches is the one scenario where it can make sense to depart from my ‘global’ advice.  I was willing to accept what I viewed as a sub-optimal geographic allocation to benefit from significant cost savings.

So resist the urge to slice and dice the world into several pieces.  It usually leads to destructive mis-behaviour and fails to fully exploit skilled active managers.  Instead, aim for broader exposure to give yourself – or your clients – the best chance of investment success.