The Myth of International Diversification

Conventional wisdom says that it is prudent to have exposure to international stocks because they can dampen the volatility of your portfolio and/or increase returns. Indeed, seminal studies throughout the 60s to the early 90s have demonstrated this to be the case. A great number of portfolios are designed on such premises. But Carl Waynberg writing for The Daily Reckoning argues that the world has changed since those early seminal studies. It's gotten smaller. International capital markets have become more integrated and more correlated! He concludes:

• International large cap stocks are much more correlated with each other than they used to be, because they are mainly driven by global factors
• Small cap stocks of various countries are much less correlated with each other, and with large cap stocks, because they are mainly driven by local factors

International Diversification: A Literature Review

Since Grubel (1968), Levy and Sarnat (1970), and Solnik (1974) first
released their research on the subject, many other studies have also
documented the gains that result from international diversification.
It's widely recognized that those gains have been possible because of
the relatively low correlation among international and domestic
markets and because, as Heston and Rouwenhorst ("Does industrial
structure explain the benefits of international diversification?"
1994) and Griffin and Karolyi ("Another look at the role of the
industrial structure of markets for international diversification
strategies," 1998) demonstrated, the low correlations were a function
of country-specific not industry-specific factors.

But the world has changed since those early seminal studies. It's
gotten smaller. International capital markets have become more
integrated and more correlated.

Longin and Solnik ("Is the correlation in international equity
returns," 1995) were perhaps the first to demonstrate the increasing
correlation among international markets in their review of data for
the period 1960-90. But many others have followed.

Carl goes on to quote several other studies which demonstrate the increasing correlation among international markets. To see a way out of the international diversification conundrum Carl looks at:

• In "Firm-Level Evidence on International Stock Market Comovement"
  (June 2005) - soon to be a major motion picture - Brooks and Del Negro
  "explore the link between international stock market comovement and
  the degree to which firms operate globally." The dynamic duo
  discovered "a large and highly significant link: On average, a firm
  raising its international sales by 10 percent raises the exposure of
  its stock return to global shocks by 2 percent and reduces its
  exposure to country-specific shocks by 1.5 percent. This link has
  grown stronger since the mid-1980s."
• Borgsen and Glaser ("Diversifikationseffekte durch Small und Mid
  Caps?" Feb. 20, 2005): "Based on an empirical analysis of European
  large, small and mid cap stock indices, we find that small caps have
  relatively low correlations not only with large caps but also with
  each other. We show that small cap stock returns cannot be spanned by
  large cap stock returns. Furthermore, we find that diversification in
  Europe is likely to be more effective with a combination of small and
  large caps than with large caps alone." The authors also conclude that "large cap returns are mainly driven by
  global factors whereas returns on small cap stocks are primarily
  driven by local and idiosyncratic factors," confirming the earlier
  work of Hansen and Rowenhorst and Griffin and Karolyi.
• Borgsen and Glaser's findings also corroborate earlier findings by
  Eun, Huang, and Lai ("International Diversification with Large- and
  Small-Cap Stocks," Mar. 2004), who put it thusly: "[R]eturns on
  large-cap stocks are substantially driven by common global factors. In
  contrast, returns on small-cap stocks are primarily driven by local
  and idiosyncratic factors. This difference in return generating
  mechanism is understandable considering that many large-cap stocks
  tend to be those of multinational companies with a substantial foreign
  customer and investor base, whereas small-cap companies are likely to
  be more locally oriented with a limited international exposure. As a
  result, the gains from international diversification with large-cap
  stocks can be modest as their returns are substantially driven by
  common global factors. However, the same skepticism may not be
  applicable to small-cap stocks as their returns are substantially
  generated by local and idiosyncratic factors. Thus, small-cap stocks
  can potentially be an effective vehicle for international
  diversification."

He concludes: It seems no matter what part of the globe, no matter what the question, the empirical evidence always points in the same direction: small caps, small caps, small caps, again and again and again. So I have one question for you: Have you hugged your small-cap guru today?

[The Daily Reckoning]

Comments

[kdewalt:]

Wonderful, but what we really need is an International Small Cap ETF. I realize that the costs and complexity are potentially inhibiting factors, but clearly there is a market need for this type of product.

2005 Sep 13 01:29 PM