Foreign Stock Investing and Diversification (EEM, EFA)

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Includes: EEM, EFA, ICF, TIP
by: Market Participant

Awhile back there controversy here at Seeking Alpha after Michael Panzer posted an innocuous chart of iShares Emerging Markets (NYSEARCA:EEM) vs iShares MSCE EAFE (NYSEARCA:EFA) suggesting that the performance gap between EEM and EFA was narrowing. I’ve found that the solution to most problems in life is muddy up the water, and statistics are great way to do that. Thanks to data from Yahoo Finance and software from SPSS (SPSS), I've drawn some conclusions about the relationships among SPX, VIX, EFA, EEM.

The first grand discovery, which many people has also discovered in the past few weeks, is that global stock markets are very correlated and they tend to be able to explain each other's variance. If you do factor analysis, the first extracted factor explains 97% of the data.

This makes sense because of the global nature of the world economy. The US and EFA economies tend to be synchronized with each other and emerging markets economies depend on exports to the developed world. The net result is that investing in foreign countries doesn't provide much if any diversification against serious market moves. At this point it seems that main benefit of investing in foreign assets is the implied hedge of foreign currency dividends against a weaker dollar. A foreign bond fund would accomplish most of the same effects with much less risk.

The other grand discovery is that EEM is strongly negatively correlated with VIX (Implied S&P 500 Volatility). This also isn't surprising because high VIX tends to be associated with market stress. For the past few years hot money has been flowing into emerging market investments through hedge funds, mutual funds, and ETFs. Much of this investment is being made without thoughtful assessment of the extra risks of investing in emerging markets. That risk includes a high beta towards the US economy and investor risk tolerance worldwide. Everyone looks like an investment genius when markets are going well. But when investors decided that volatility is a bad thing, the outflow from EEM was nasty.

The take home from all this is that you can't rely on common stocks to diversify away the inherent risks of investing in common stocks. To do that you need something other than common stock, i.e bonds (NYSEARCA:TIP). Even things like REITs (NYSEARCA:ICF) or Gold (NYSEARCA:GDX) don’t give as much diversification as you would expect.

With world markets as interconnected as they are, you can't expect EFA to be a tower of strength when SPX is crumbling.