By: Frank Armstrong
Many investors avoid international exposure in the mistaken belief that they are avoiding unnecessary risk. In fact, by failing to diversify cross border they actually increase their risk substantially. Token positions do little to benefit the portfolio. The appropriate allocation to international investments may be much higher than most investors think.
Why invest internationally?
We invest internationally primarily to reduce portfolio risk. Cross border investing brings asset classes with low correlations to our domestic holdings, resulting in lower volatility for the investment plan. There is a wealth of academic theory and real world experience to support this thesis, but many investors remain skeptical. Many investors confuse what is familiar with what is safe they don’t realize that it’s not better or safer just because it’s in your local neighborhood. While Americans are particularly myopic in this regard, it is not solely an American foible. Investors in every country display a local market preference.
A portion of this local market preference is seemingly rational. We all spend and measure our wealth in local currency. However, the benefits of cross border diversification swamp currency risk in the equity markets. Over time, the currency risk balances out. But, in the short run cross border diversification is a fine way to hedge against a loss of value of your currency. If, for instance, the value of the dollar declines, all foreign stocks held by an American will appreciate in value by an identical amount. So, foreign currencies add an additional diversification benefit to the portfolio.
Us Against Them Mentality
Perhaps because we are all descendants of hunter-gatherer tribes, we fall prey to an us-against-them-mentality. If they aren’t in our tribe, they must be enemies. For investors, other cultures and markets may appear to be suspect, with funny money, governments, food, laws, religions, regulations, eyes, language, ethics, and work habits. If you harbor this view consciously or unconsciously the logical extension is to avoid investing with these infidels.
It doesn’t matter whether you or the investor happen to live in New York or New Caledonia. This irrational local market preference does little to enhance your investment portfolio.
The world’s markets are efficient. Certainly it’s absurd to believe that any single market could return abnormally high-risk adjusted returns without attracting so much capital that returns would quickly fall to “equilibrium” levels. While equilibrium levels exist only in the dreams of economists, we do know that cash flows follow returns, and returns are mean reverting. Were it not so, a country or region with sustained higher than global risk adjusted returns would eventually own all the world’s capital. Perhaps this is possible, but it has never happened before, which gives me a strong hint that it’s not likely to happen this time either. There simply is no single country, not even the U.S., that has a lock on better than average returns.
On the other hand, no investor would continue to accept sub-standard returns in his local market if better returns were available elsewhere. Either prices on the local market adjust downward until expected returns are in line with global expectations, or the investor turns overseas. Actually both happen at once as markets adjust through the normal arbitrage process.
If in the long run, market returns are similar for similar risks and in the short run, they behave differently. The markets do not move in lockstep, giving us an opportunity to reduce risk by adding asset classes with low correlations to our domestic portfolio.
Ideal Amount of International Exposure
If you are with me so far, the next question is how much international exposure is ideal. We won’t know precisely until about 100 years from now when we meet with the clarity of 20/20 hindsight. But, there is strong academic theory coupled with real-world experience to help us with an estimate:
- Somewhere out there is the super efficient portfolio. This portfolio generates the highest return per unit of risk of any portfolio in the universe. Every investor, no matter where he was, that desired a risky asset would wish to hold this dominant portfolio. ý Tobin’s Separation Theorem.
- One of the most useful strategic implications of Capital Asset Pricing Model (CAP CAP-M) is that the super efficient portfolio is the world market. An investor should desire his pro rata share of all the world’s traded equities.
- Subsequent research by Gene Fama and Ken French demonstrated that tilting a portfolio toward small companies and value (distressed) companies offers the opportunity for increased returns over the global market. The Three Factor Model has replaced CAP-M as the asset-pricing model of choice.
So, the appropriate equity portfolio is globally diversified with a tilt of some magnitude towards small and value companies.
The concept of a globally diversified portfolio as the optimum investment mix is widely accepted in academia and institutional practice. As an example, one recent calculation found that the S&P 500 is 150% as risky as the better diversified global index.
Depending on who’s counting, what measurement they are using, and what time frame they’re looking at, the U.S. is about 35% of the world’s markets. So, it follows that at least ½ of your equity portfolio should be in foreign assets. Anything less actually increases risk! Investors must have a very strong reason to deviate from this policy.
However, some investors are shocked when introduced to an appropriately weighted portfolio. The difference in perception is remarkable. Investors believe that the global portfolio is far too risky, while we believe it’s the lowest risk equity portfolio available.
Global investing is a relatively new concept for U.S. investors. Pioneers like Sir John Templeton had an uphill battle convincing Americans to invest any money at all outside of their borders. During the early 80s, many mutual fund companies embarked on a campaign to widen investor horizons. As part of that effort, they published and widely circulated a study illustrating the benefits of foreign diversification using Modern Portfolio Theory. The example compared portfolios with various weightings of the S&P 500 and EAFE (Morgan Stanley MS +0.78%’s Europe, Australia, and Far East Index, often used as a proxy for large foreign companies in developed markets). The optimum portfolio was found to have 20 to 30 percent foreign.
The campaign had an unintended consequence. While the illustration may have moved some investors from zero to a token weight in foreign, many investors and advisors fixed on the optimum point at 20 to 30 percent as a maximum foreign weighting. This maximum weight conventional wisdom has become ingrained in the collective psyche. Today, this knee-jerk reaction goes virtually unchallenged.
Real World Limitations
Investors must consider the real-world limitations of the example. It was time specific. Do the illustration with any other set of data, you’ll get a different result. Worse yet, the investor’s choices were restricted to just two asset classes. If you consider multiple asset classes like foreign small and foreign value, which have both higher expected returns than either EAFE or S&P 500 and very low correlations to domestic asset classes, and you will get a much higher optimum percentage for foreign assets.
The choice of S&P 500 and EAFE for the illustration was also unfortunate. These two asset classes are very highly correlated and provide little in the way of a diversification benefit. The real benefits of foreign investing occur when foreign value, foreign small and foreign small value asset classes are mixed with domestic assets. Here we obtain both higher expected returns and very low correlations.
The “super efficient” equity portfolio, the one that yields the highest expected return per unit of risk, is the global equity portfolio. The appropriate weighting for foreign investments is the pro rata share of the world’s capital markets. Anything less than true global diversification increases risk without increasing expected return, and provides a sub-optimal investment solution.
Appropriate portfolio construction includes a tilt toward smaller and value companies on a global basis. Index funds provide economical and highly effective exposure to the world’s markets, and allow the portfolio to be structured to capture these additional risk dimensions and associated incremental returns.