On International Diversification

Markets are more correlated in the short term but strongly diverge in the long term.
Currency movements further fuel international divergence.
Being overweight a certain market or currency means carrying additional risks that could be removed by international diversification.

Introduction

One issue that is more often off than on investors’ minds is international diversification. Historically, cross-country equity correlations have been far from perfect but they are becoming more correlated in recent times. The higher correlation is not a reason to shun international diversification.

Figure 1: Cross-country correlation of stocks and bonds. Source: Viceira, Wang, Zhou – Harvard Business School.

The main point behind international diversification is that due to the lower correlation between markets it should lower the risks by smoothening the volatility of a portfolio for the same expected return. This happens because the international part of the portfolio is less likely to be affected by domestic market changes. The globalization of trade flows and higher capital markets integration increased the international correlation among markets and consequently lowered the potential benefits. But, as correlation is always measured in the short run, in the longer term it should bring to the expected benefits of reaching the same returns with lower risk because the long term correlation is much lower.

Lower Long Term Correlation of International Markets

The long term correlation among international markets is lower than the short term due to several reasons. The first one is that even if in the short term the global integration of capital markets makes it look like they are correlated, in the longer term structural influences prevail. The following two figures show the difference between short and long term correlation.

Figure 2: 1-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

The difference among the above indexes in one year is only 10% with the AEX being the worst performer. This small difference makes investors forget about international diversification. But in the long term things are completely different.

Figure 3: 10-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

In the longer period of 10 years the differences are much larger. The Brazilian index is the most volatile and the S&P 500, AEX and FTSE move along for a while but strongly diverge in the total period. The above figures show the movement of the relative stock market indices without taking into account currency effects. Currency effects are the second important factor in international diversification. The below figure shows the example of the USD/EUR currency pair.

Figure 4: USD/EUR currency pair from 2006 to 2016. Source: XE.com.

On top of the previously explained market divergence the dollar strengthened in relation to the EUR from 0.62 EUR per 1 USD in 2008 to the 0.95 EUR per 1 USD. That represents a divergence of more than 50% and shows how the currency effect can influence international correlation in the long term. Currencies are strongly influenced by economic trends and that is the third factor influencing international correlation.

Economic Influences

The below cumulative GDP growth chart shows how countries experience different growth levels in longer periods. The UK and the US have grown 50% faster than the Netherlands while Brazil grew 100% faster than the US in the period from 2000 to 2015.

Figure 5: Cumulative economic growth for the US, UK, Netherlands and Brazil from 2000 to 2015. Source: World Bank.

Economic divergences are a consequence of longer term structural effects and global cycles. Currently the Euro is considered weak due to the low interest rates in Europe, slow economic growth and no short term positive economic catalysts on the horizon. On the other side, due to the weakness of the currency European products are cheaper internationally and that could influence faster economic growth in the future. In the meantime, the strong dollar makes US products globally more expensive and this could lower the currently stronger economic growth of the US.

The above long term factors also lower the risk of a portfolio in a long term and are important factors to think about when investing. But, even if the benefits of portfolio diversification are clear in the long term, investors stick to their domicile markets. This phenomenon is called the equity home bias puzzle.

Equity Home Bias Puzzle

An interesting feature in the international markets is the home bias. It describes the tendency to invest the largest part of one’s portfolio in domestic securities despite the benefits of international diversification. University of Chicago researchers, Moskowitz and Coval have found that specifically US investment managers exhibit a strong preference for locally headquartered firms that often create asset pricing anomalies. A Morningstar research in 2013 found out that US mutual fund investors keep only 27% of their equity allocation in not US domiciled funds while the Equities not domiciled in the United States accounted for 51% of the global equity market. It is logical that investors prefer the familiar but each investor should assess its own exposure to a certain currency and evaluate his long term risks related to that exposure.

The Strength of the Dollar

Being overweight one market means betting on the success of that currency or market in relation to other markets and currencies. Therefore, such an overweight investor has to assess potential international macroeconomic influences on his portfolio. Such long term economic shifts are very difficult to time and therefore considered betting. US investors have had a great investing performance in the last few years with Europe starting quantitative easing, commodities, that are the main wealth resource of emerging markets faltering and China experiencing a soft landing. But, the below figure that compares the US dollar to a basket of foreign currencies shows how risky an overweight currency strategy can be.

Figure 6: US dollar index from 1967 to 2015. Source: Wikimedia.

An astute investor could also use the above evident shifts and allocate different weights to various markets in relation to their current weakness but that is a different story and requires high macroeconomic knowledge and insight.

Conclusion

The main idea behind this article is to give food for thought. International diversification might not be relevant in the short term but in the longer term it can provide certain benefits. There are various ways of being internationally diversified, through buying different indices or by buying stocks of the same sector that have a different geographic focus. A clear example for that are utilities, they provide relatively stable returns and dividends and when dispersed internationally can lower the volatility of a portfolio.