Diversifying Your Portfolio Using ETFs -- It Ain't So Simple

Roger Nusbaum submits: Bob Pisani was on a new riff yesterday saying the S&P 500 is a global index, not a U.S. index, because 48% of the earnings reported by its components come from overseas.

On the surface I disagree completely. Global companies can benefit from doing some portion of their business overseas, but this does nothing to somehow increase the correlation of a U.S. stock to the index of some foreign market it does business in.

To the extent that the 48% smooths out the earnings of the index it is a positive, but again there is no magic bullet for increased correlation.

It is perfectly valid to buy a company because it benefits from its overseas business, but you are likely to be disappointed if you expect a U.S. multinational to track some other country. I have made this argument several times in the past.

Let's look at it the other way -- let's say Bob is right -- the S&P 500 is a global index for the very reason he says. Markets are becoming more globally interdependent. We have all heard this and it makes sense, even if the extent of globalization could debated.

If this is true, and it may be, then this is all the more reason to not think of iShares MSCI EAFE (EFA) as a good way to diversify your portfolio -- a subject I wrote about the other day. Maybe EFA should instead be thought of as a substitute for some portion of the dollars allocated to S&P 500 Index (SPY) and other broad-based index funds?

Sound crazy? Well maybe it is. But SPY and EFA have a 0.846 correlation (according to PortfolioScience.com). The dollar might continue to get weaker and the markets that dominate EFA may continue to outperform the U.S. market.

Really the point here is more of a reiteration of what EFA cannot do for a portfolio which, in my opinion, is create diversification for the few times during a stock market cycle when you most need it.

To the extent that this holds water, it speaks to the rolling up of the sleeves that investors need to do to one way or another to create diversification for themselves. Of course that assumes that most investors are interested in the type of diversification that gives the chance for a smoother ride during rocky times.

Comments

[Geoff Consi...:]

Roger:

My goodness--we agree again! I got about a 0.82 correlation for monthly total returns over the four years through Sep 06 between EFA and SPY:

etf.seekingalpha.com/a...

I had not seen that # before--that 48% of the earnings of the S&P500 is from overseas. That certainly helps explain some of the high correlation. My take away is that EFA (EAFE) will not provide the substantial diversification that people expect--a point that I have made in a number of my articles. I think that EAFE and SPY look more and more similar in terms of risk/return profiles over time--part of the consequence of the higher correlations.

2007 Apr 25 01:28 PM

[Johnny Bitc...:]

You people are confused:

1. Nusbaum's response to Pisani's claim that the S&P is a global index is flawed. Pisani said nothing about using the S&P to track a specific country, which is a ridiculous non sequitor.

The natural understanding of Pisani's observation would be that the S&P has a high correlation with returns and growth in the developed countries in the aggregate, not that it should be used to track Japan for chrissake.

2. Given the uncertainty around the different exchange rate hedging strategies of the multinationals withing the S&P 500, it's tough to quantify the risks and benefits of the foreign cash flows.

Let's keep it simple:

1. Continued global integration in general should lead to more diversified revenues and profits for the S&P 500 over time leading to a lower risk premium and higher value for the index.

2. Exchange rate risk is probably a complete wash, but difficult to prove.

3. Falling dollar should result in higher translated revenues/profits.

My guess is that item number 3 is the reason for general market strength. Item 1 helps but isn't the driver. Item 2 doesn't matter much.

john.

2007 May 03 04:58 PM