Turns out, increasing foreign exposure will have little impact on Vanguard funds-of-funds

Vanguard Finally Charts Course for International Bonds

For years, Vanguard resisted offering a foreign bond mutual fund, but in 2011 it seemingly caved to investor demand and announced the launch of two index funds one for foreign developed markets and one for emerging markets. However, as their release date approached, the funds’ introduction was postponed.

A year later, Vanguard finally will offer one of them to investors.

Vanguard’s Total International Bond Index Fund is slated to launch by the end of the second quarter. Vanguard seems to be a bit more serious about bringing it to market this time around, announcing that the fund will be added to 20 of its funds-of-funds, including the Target Retirement. STAR (MUTF:VGSTX ), LifeStrategy and Managed Payout series. It will account for 20% of the bond allocation in each portfolio. Why 20%? Beats me. Vanguard has 30% of stock exposure in its funds-of-funds going to foreign stocks. But 20% has been deemed the appropriate number for bonds.

As a reminder (and it’s been awhile, so you’re forgiven if you don’t remember), the Total International Bond Index will track a Barclays index of foreign developed market bonds that eliminates currency risk the tongue-twisting Barclays Global Aggregate ex-USD Bond Float Adjusted RIC Capped (Hedged) Index. Vanguard has argued that the currency piece of foreign bonds is what adds the most risk. Removing that component leaves investors with a more bond-like experience.

While we agree with the premise, we’re not sure what return or risk edge the new fund will bring, if any, over Vanguard Total Bond Market (MUTF:VBMFX ). Over the past 20 years, Total Bond Market returned 6.2% a year, while Total International Bond Index’s bogey gained 6.4% a year. Given that Total Bond Market is net of fees and the foreign index has none, we can call that a wash. On the risk side, as you might expect, the foreign bond index was a bit more volatile, with a maximum cumulative loss (MCL) of 6.3% compared to Total Bond Market’s MCL of 5%.

OK, but what about as a part of a diversified portfolio? Surely then the diversification benefits shine? Using STAR LifeStrategy Moderate Growth ’s (MUTF:VSMGX ) allocation (60% to stocks and 40% to bonds) as an example, let’s compare the long-term performance of two hypothetical portfolios: One with an 8% foreign bond component (which represents Vanguard’s proposed 20% bond allocation to the new international index); one without. The table below shows how the two portfolios are allocated:

How Will Vanguards Changes Affect a 60/40 Stock/Bond Portfolio?