Ever since the financial crisis, when the correlation of all risky assets rose toward 1, investors have been hearing that the world has become flat and the benefits of international diversification are gone. The explanation generally is that the world market has become more integrated and financial markets more globalized.
The Power Of Mononationals
Cormac Mullen and Jenny Berrill contribute to the literature addressing the merits of international diversification with the study “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” which appeared 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 called mononationals.
The authors 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 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.”
While their conclusion does have the benefit of being intuitive, there’s really nothing new here. Multinationals are more likely to be large companies, and mononationals are more likely to be smaller companies. Additionally, it has 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 1994 issue of Financial Analysts Journal, showed that international small stocks diversified U.S. portfolios more than the large stocks of the EAFE Index.
While foreign large companies do have exposure to their domestic economies, their earnings are more likely to be impacted by global conditions than the earnings of smaller companies, which tend to be more dependent on the conditions of local economies. Thus, their returns are driven more by local, idiosyncratic factors. This makes them a more effective diversifier than international large stocks.
As an example, the performance of two giant, global pharmaceutical companies (like Merck and Hoffmann-La Roche) is likely to be more highly correlated, because their products are sold around the globe, than the performance of two small-cap domestic restaurant chains whose products are sold only in their home countries.
When designing a portfolio, all else equal, investors should prefer to add asset classes that have lower correlations. With that in mind, to see which international asset classes provide the greatest diversification benefits, we will look at correlation data for various asset classes.
The table below shows the semiannual (instead of annual) correlations for the longest period for which we have data, January 1994 through June 2017.
The international indexes are provided by Dimensional Fund Advisors (DFA). (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)
As you can see, the benefits of international diversification are greater when investing in international small and small value stocks and in emerging markets than when investing in the international large stocks in the EAFE Index.
Because of the lower correlations of international small and small value stocks, as well as their higher forward-looking return expectations, investors should strongly consider including an allocation to them when constructing their portfolios. All too many investors include only an allocation to funds tracking the EAFE Index or the Total International Markets Index.
The bottom line is that, if you want to improve the diversification benefits of your international stocks, increase your exposure to small and small value stocks, both in developed and emerging markets.
That will provide you not only with the benefits associated with reduced correlations, but with greater exposure to the size and value premiums, which have been just as persistent and pervasive internationally as they have domestically. You can see the evidence on their returns in my latest book, co-authored with Andrew Berkin, “Your Complete Guide to Factor-Based Investing.”
We have one more point to cover. When thinking about the benefits of diversification, it’s important to understand that correlations are not the only element that matters. As long as there’s a dispersion of returns, there are diversification benefits—and in each year since 2008, there has been a wide dispersion of returns.
Dispersion Of Returns
- In 2009, we saw very wide dispersion of returns. For example, while the S&P 500 was up almost 27%, the MSCI Emerging Markets Index rose 79%. And emerging market small and value stocks produced even higher returns. In addition, international large value and small value equities, as well as international REITs, managed to outperform their domestic counterparts by wide margins. Note that while correlations were positive, as all equity asset classes produced above-average returns, the world didn’t look very flat in 2009.
- In 2010, even though the S&P 500 returned about 15%, emerging markets stocks outperformed it 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 more than 2%, in general, international stocks showed negative returns. 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 equities 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, in general, not only far outperformed international stocks, U.S. stocks rose and developed, non-U.S. markets generally fell. Again, the world sure 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 very flat at all.
- In 2016, the world also wasn’t totally flat. While Vanguard’s 500 Index Fund (VFINX) returned 11.8%, its Emerging Markets Index Fund (VEIEX) did return an almost identical 11.5%. DFA’s passively managed Emerging Markets Small Cap Fund (DEMSX) returned a similar 10.9%, but its Emerging Markets Value Fund (DFEVX) returned 19.8%.
- So far in 2017, we are again seeing that the world isn’t flat. For example, through July 31, while VFINX was up 11.5%, the Vanguard Developed Markets Index Fund (VDVIX) was up 17.9%, VEIEX was up 20.8%, and international small and small value stocks outperformed domestic stocks by wide margins. As one example, while the DFA U.S. Small Cap Value Fund (DFSVX) had produced a loss (-1.1%), its International Small Cap Value Fund (DISVX) returned 18.9%, an outperformance of 20.0 percentage points. This was a virtual reversal of 2016’s relative performance, when DFSVX returned 28.3% and outperformed DISVX’s return of 8.0% by 20.3 percentage points.
Despite markets becoming more integrated and correlations rising somewhat, there are still wide dispersions of returns—showing benefits to diversification even in a flatter world.
Hopefully, the evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they certainly have not disappeared. Thus, broad global diversification is still the prudent strategy.
A good starting point for determining how much to allocate to international markets is global market capitalization, which currently has a weighting of roughly one-half U.S. stocks, three-eighths non-U.S. developed markets, and one-eighth emerging markets. Investors more subject to the dreaded psychological risk of tracking-error regret may decide to incorporate a home-country bias.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.