In Search Of A Global Index Fund

None existsyet. But Wall Street's quants are on the case

In the late 1990s, as they were pacing around a green room waiting to start a televised panel discussion, Nobel laureate William Sharpe and veteran Wall Street rocket scientist Martin Liebowitz got into a friendly debate. They argued about what would be an appropriate asset-allocation benchmark for a global portfolio. They didn't reach a conclusion, but both admitted that their personal investments were less international than they should be. "I think indexing the world is a nifty idea," Sharpe recently said, recalling the moment. "Unfortunately, the world market portfolio doesn't exist."

Investors can assemble a portfolio made up of exchange-traded funds and indexed mutual funds that mimic pieces of the world's stock and bond markets. Still, it would be only a crude approximation, and some important components—such as an international bond index fund—do not yet exist. But sometime in the next year or so, Wall Street's index mavens may well come up with the Holy Grail of investing—a single-purchase, low-cost, indexed global portfolio.

If such a fund could be developed, the MSCI Global Capital Markets Index could be the foundation. It's composed of publicly traded stocks and bonds —11,000 securities in all. Index designers are also trying to figure out how to fold in commodities, real estate, even private equity. "We're moving toward a global wealth portfolio," says David Darst, chief investment strategist for Morgan Stanley's (MS ) Global Wealth Management Group.

A basic global portfolio would be about 60% stocks, 40% bonds, the same benchmark allocation commonly used for a U.S.-only mix. Both the stock and bond portions of a global portfolio would be about half U.S. securities. Some 85% to 90% of the remainder would be from developed markets in Europe and Japan, the rest from emerging markets such as China and India.

Does this mean U.S. investors, who have about 10% of their assets abroad now, should ramp up to 50%? In most cases, no. Modern portfolio theory—and Sharpe is one of its founders—holds that an investor should own everything in proportion to its capitalization in the world's markets. But most of us don't own homes all over the world and consume goods and services from everywhere. Says Ross Levin, a certified financial planner and head of Accredited Investors in Edina, Minn.: "I still want a bias toward dollar assets since most of my clients are still spending dollars."

Then just how much should be international? Many financial advisers suggest that high net worth clients go up to as much as 30%, which is still a radical departure from the past. "Younger people are more open to the idea that international should be a large part of their portfolio," says Mark Balasa, co-owner of finance-planning firm Balasa Dinverno & Foltz in Itasca, Ill. Many clients, especially those 55 and up, are resistant. "They see it as too risky," Balasa says.


Portfolio theory holds that more diversification—and you can't get more diversified than a truly global portfolio—diminishes risk and enhances return. How so? Markets don't move in tandem, so if your investments in one sector are sagging, they may be shining somewhere else. But in recent years, as the world's economies became more intertwined, the markets have become more correlated—that is, they're more likely to move in the same direction at the same time.

Yet investors, even professional ones, tend to misinterpret the relationship between correlation and the benefits of diversification, argue Meir Statman, finance professor at Santa Clara University, and Jonathan Scheid of Bellatore, a financial-services firm in San Jose, Calif. The recent correlation between the returns of U.S. and international stocks is high, but the gap between the two is also high. For instance, the three-year return (through Nov. 30) of the Vanguard Total International Stock Index Fund (VGTSX ) is 22.6% and the Vanguard Total Stock Market Index Fund (VTSMX ) is 14.6%. The year-to-date gap is 22.8% and 14.2%, respectively. Investors who concentrated their portfolios in the U.S. during this period badly lagged behind those who diversified worldwide.

If you're looking to globalize your portfolio now, those two Vanguard funds would provide a good base. They're not a complete solution, but with a bond component, they will suffice until Wall Street finds the Holy Grail.

By Christopher Farrell

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