Take The Long View
While international diversification doesn’t necessarily work in the short term, it does eventually. This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually).” They explained that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long term (and it should be, or you shouldn’t be invested in stocks to begin with) should care more about long-drawn-out bear markets, which can be significantly more damaging to their wealth.
In their study, which covered the period 1950-2008 and 22 developed-market countries, the authors examined the benefit of diversification over long-term holding periods. They found that, over the long run, markets don’t exhibit the same tendency to suffer or crash together. Thus, investors shouldn’t allow short-term failures to blind them to long-term benefits.
To demonstrate this point, they decomposed returns into two pieces: (1) a component due to multiple expansion (or contraction); and (2) a component due to economic performance. They found that while short-term stock returns tend to be dominated by: (1), long-term stock returns tend to be dominated by (2). They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”
They further showed that “Countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”
For example, in terms of worst-case performances, they found that, at a one-month holding period, there is very little difference in performance between home-country portfolios and global portfolios. However, as the horizon lengthens, the gap widens—the worst cases for the global portfolios are significantly better (the losses are much smaller) than the worst cases for the local portfolios. And the longer the horizon, the wider the gap favoring the global portfolios.
Demonstrating the point that long-term returns are more about a country’s economic performance and that long-term economic performance is quite variable across countries, they found that “Country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”
The next issue we’ll discuss relates to the question of whether owning U.S. multinationals is the way to gain international diversification.
Effective International Diversification
Cormac Mullen and Jenny Berrill contribute to the literature on the benefits of international diversification with their study “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” which was published in the Second Quarter 2017 issue of Financial Analysts Journal.
Mullen and Berrill showed that one way to recover international diversification benefits is to decrease the internationalization in investors’ portfolios by lowering exposure to the stocks of foreign multinationals and focusing on what they call “mononationals.”
They concluded: “Despite the decrease in international diversification benefits documented in recent papers—and a research focus in recent years on the benefits of stocks from emerging and frontier markets—we found that there is still international diversification potential in developed-market equities. We suggest that a portfolio of international stocks classified solely as domestic offers the potential for more international diversification benefits than a portfolio of more-internationalized stocks.”
Their conclusion has the benefit of being intuitive. That said, there’s really nothing new here. Multinationals are more likely to be large companies, and mononationals are more likely to be smaller companies. It’s long been known that the benefits of international diversification are greatest when investing in smaller companies.
For example, Rex Sinquefield’s study “Where Are the Gains from International Diversification?”, which appeared in the January-February 1996 issue of the Financial Analysts Journal, showed that international small stocks diversified U.S. portfolios more than did the large stocks of the EAFE Index.
While foreign large companies have exposure to their domestic economies, their earnings are more likely to be impacted by global conditions than those of smaller companies, which tend to be more dependent on the conditions of their local economies. Thus, the returns of smaller companies are driven more by local idiosyncratic factors. This makes them more effective diversifiers than international large stocks.
As an example, the performance of two giant global pharmaceutical companies like Merck and Roche is likely to be more highly correlated—because their products are sold all around the globe—than the performance of two small-cap domestic restaurant chains whose products are sold only in their home countries.