Swedroe: Benefits Of Int’l Diversification

April 03, 2019

  • In 2010, even though the S&P 500 returned about 15%, emerging market stocks outperformed by about 4 percentage points. On the other hand, U.S. large, large value, small, small value and REIT funds outperformed their foreign counterparts by significant margins.
  • In 2011, while the S&P 500 returned just greater than 2%, international stocks generally provided negative returns. For example, the MSCI Emerging Markets Index lost more than 18%.
  • In 2012, the relative performance of U.S. and international funds reversed: International funds outperformed their U.S. counterparts in all asset classes, although the return differences were relatively small.
  • In 2013, U.S. stocks outperformed international equity by wide a margin. For example, the S&P 500 Index, which returned 32.4%, outperformed the MSCI EAFE Index by about 10 percentage points and the MSCI Emerging Markets Index by approximately 35 percentage points. The world didn’t look very flat in 2013, either.
  • In 2014, domestic stocks generally far outperformed international stocks, as U.S. stocks rose and developed non-U.S. markets generally fell. Again, the world didn’t look flat.
  • In 2015, returns were all over the place. For instance, U.S. large stocks and developed non-U.S. stocks produced similar returns, both close to zero. On the other hand, the MSCI EAFE Small Cap Index rose about 10%, while the MSCI EAFE Small Value Index rose roughly 5%. Their U.S. counterparts lost 4% and 5%, respectively. At the same time, the MSCI Emerging Markets Index lost almost 15%. Once again, the world didn’t look flat.
  • In 2016, the world wasn’t totally flat. While the S&P 500 returned 12.0%, the MSCI Emerging Markets Index returned an almost identical 11.6%. However, the MSCI EAFE Index returned just 1.5%. Here’s another example: While the MSCI US Small Value Index returned 27.6%, the MSCI EAFE Small Value Index returned just 6.4%.
  • In 2017, we saw again that the world isn’t flat. For example, while the S&P 500 Index returned 21.8%, the MSCI EAFE Index returned 25.6% and the MSCI Emerging Markets Index returned 37.8%. As another example, while MSCI US Small Value Index returned 9.2%, the MSCI EAFE Small Value Index returned 30.9%—almost a complete reversal of the prior year’s returns.
  • 2018 was no different. While the S&P 500 Index lost 4.4%, the MSCI EAFE Index lost 13.4% and the MSCI Emerging Markets Index lost 14.2%.

These examples demonstrate that correlations don’t tell the true story about the benefits of international diversification. To see the benefits, you have to also look at the dispersion in returns. The bottom line is that, despite markets becoming more integrated and correlations rising somewhat, there is still wide dispersion of returns—showing the benefits of diversification even in a flatter world.

Summary

The evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they have not disappeared.

The conclusion that Asness, Israelov and Liew drew in their study “International Diversification Works (Eventually),” and the one you should draw, is that while global diversification can disappoint over the short term, over the long term, which is far more relevant, “It is the free (and hearty!) lunch that theory and common sense says it should be.”

If you need a specific example of the wisdom of this advice, look to Japan. Clearly, Japanese investors have benefited from global diversification. The poor returns Japan experienced since 1990 (from 1990 through 2018, the MSCI Japan Index returned 0.18%) weren’t a result of systemic global risks. They happened because of Japan’s idiosyncratic problems.

Before you make the mistake of confusing the familiar with the safe, you cannot know which country or countries will experience a prolonged period of underperformance. That uncertainty is what international diversification protects you against.

Broad global diversification is still the prudent strategy. As Vanguard recommended, a good starting point for deciding how much to allocate to international markets is the global market capitalization. That said, there are some valid reasons for a U.S. investor to have a small home country bias.

When investing internationally, implementation costs can be higher in terms of expense ratios of funds, trading costs and taxes. Thus, while the global market capitalization is a good starting point for allocating capital, the higher costs of investing internationally might lead to a slightly higher allocation to U.S. stocks.

On the other hand, if you are still employed, your labor capital is likely to be more exposed to the idiosyncratic risks of the U.S. economy. Thus, if your labor capital is highly correlated to the U.S. economy, you might consider an even higher allocation to international stocks.

Hopefully, the evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they have not disappeared. Broad global diversification is still the prudent strategy.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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