International Asset Allocation Revisited

by: Martin Lowy

In an article titled "A Portfolio for the Next Market Crash", I discussed portfolio allocation in the context of a set of expectations triggered by predictions of the growth of global capital resources. Basically, those expectations are (1) that short-term interest rates will remain low for quite a while, (2) that the equity markets are likely to outperform cash and bonds over the medium term, and (3) that equities are going to get quite overpriced, which likely will mean a negative market event at some time over the next five years. Commenters were quick to point out that I had not allocated any of the hypothetical portfolio to non-U.S. equities. I responded that I would write an article explaining why I had not. I have limited this article to foreign equity securities because I was talking about international stocks, not other types of securities.

Basically, although I maintained a part of my portfolio explicitly in international stocks for many years, I now believe that is not necessary for many American investors. The basic reason is that so many companies based in the United States are international.

What Is International Diversification For?

When we evaluate the benefits of international diversification, what are we looking for? Are we looking for diversification by headquarters? By national origin of the CEO? By the nationality of the board of directors? I do not think any of those things is what we are looking for. I think we are looking to benefit from a diversity of markets and a diversity of sources of basic materials and manufacturing facilities. We also may be looking for exposure to currencies other than the U.S. dollar, but I am not certain that is necessary.

In the 21st century business world, companies sell their products and services all over the world. Pretty much every company of any size is trying to sell in all the world's major markets. Some are more successful than others at doing so, but that does not seem to depend on where they are based. Sales of the S&P 500 are now almost 50% outside the U.S., for example, up from about 30% just a dozen years ago. See here. Look at almost any major company, and non-U.S. sales will make up a substantial part of their revenue. And if you look at where they expect growth to come from in the future, you will find it expected in the lower-GDP-per-head countries with large populations, not in the U.S. or Europe.

Look at where companies manufacture. Except for some European companies that are sort of forced by their governments to manufacture locally, all companies manufacture where it is most efficient and cost-effective to do so, regardless of whether that is in China, India, Bangladesh or Cleveland. All companies also source their raw materials on the same basis: Where can they get the best at least cost? Transportation costs do come into play, but they sway location only in a small percentage of cases. Political stability also is a factor in decisions as to where to manufacture. But that also is a cost that is ground into the decision-making process.

Do American investors need exposure to foreign currencies? Perhaps such exposure is useful as a hedge to some extent. But if one invests in a large company, that company will have exposure to a variety of currencies and will, to the extent it deems prudent, hedge those currencies. If my expenses are in U.S. dollars, how much exposure do I need to the euro and the yen? Well, one may say, the dollar is going to hell in a hand basket. Just look at how little a dollar buys today compared with thirty years ago. Yes, it is true that a dollar ain't what it used to be. But think about how the global floating exchange rate system works. If the dollar weakens relative to other currencies, U.S. exports will benefit, which will benefit American companies and jobs. If the dollar strengthens, it will buy more for you.

That does not mean you should not use your portfolio to hedge against the dollar buying less. One way to do that is to buy oil company stocks. Oil has been a good proxy for hedging the dollar. Here is a graph that suggests how oil has hedged the U.S. dollar versus the Canadian dollar in recent years.

Oil also basically tracks the price of gold (or vice versa), making it a double play as a hedge. Here is a graph of the number of barrels of oil an ounce of gold will buy. Over the 40 or so years in the graph (basically since gold was de-controlled), an ounce of gold has, with temporary variations, bought about 15 barrels of oil.

Even in terms of who is running a company today, American corporations have become internationalized. Coke and Pepsi, for example, have been run by executives born outside the U.S. Most American companies seek executives who can be identified as international to run various parts of their international businesses. The day of the "Ugly American" mostly is over.

Historical Comparisons

One of the appropriate ways to look at this question is to ask what difference it would have made to have invested more internationally over the last five years. That is a good period to look at because it included a major market discontinuity as well as periods when different developed world economies were performing differently. (Longer periods might have two defects: one, they might go back before internationalization, and two, the relevant EFTs might not go back that far.) I will assume that an S&P 500 ETF (NYSEARCA:SPY) or the Wilshire 5000 Index (NYSEARCA:WFVK) is an appropriate U.S. stocks benchmark. Here is a graph of the performance of SPY (from Yahoo):

Here is the Wilshire 5000 for the same period (from the official website):

As we can see, the differences are minimal. Both are up about 100% since the lows of 2009, and the shape of the graphs at almost all points is the same. Can we say the same for some international examples?

Here is a similar graph (from Yahoo) for iShares MSCI ACWI Index (NASDAQ:ACWI), a broad-based international ETF that is about 42% U.S.:

There are differences between the U.S. funds and indexes and the ACWI. But once again, they are minimal. They would not have affected one's 5-year return in any material way.

Many of the international-only ETFs do not have 5-year records that we can compare. That is true for iShares Core MSCI Total International Stock ETF (NYSEARCA:IXUS) and Vanguard Total International Stock Index ETF (NASDAQ:VXUS), for example, two of the quality international index funds that exclude the U.S. iShares MSCI EAFE Index (NYSEARCA:EFA), that also is a broad-based, non- U.S. fund, does have a 5-year record, graphed as follows (courtesy of Yahoo):

Again, the pattern is similar, though the U.S. stocks outperformed some of the rest of the world in 2012.

Thus it appears that in recent years, broad-based stock indexes are correlated, both internationally and in the U.S. That is not surprising if most substantial companies, wherever they are headquartered, are seeking the same markets and utilizing the same global manufacturing strategies. I assume that from time to time non-U.S. stocks will outperform U.S. stocks (and vice versa), but it appears that over the long haul, the differences may be disappearing. That does not mean they could not reappear, but I do not see a basis at this time for believing that headquarters location is going to be the driving force of differentiation-or if it is, I would bet on the U.S. coming out ahead. See the last paragraph of this article, please.

Different Cultures

Does the internationalization of American companies mean that Americans should not buy international companies headquartered outside the U.S.? No (please excuse the double negative). I merely advocate that HQ location means relatively little in terms of internationalizing one's investment exposure.

There are ways that companies headquartered outside the U.S. may well differ from many U.S. companies. Some of these ways may be beneficial. But many of them may be bad for investors. Let's take the idea of a corporate culture. Corporations do have them, regardless of whether they are intentional. Almost all of the large banks that have been caught up in the scandals involving LIBOR, EURIBOR, and violating U.S. sanctions on Iran have been based in Europe. Many of those banks, thinking they had to compete with the cowboy culture of U.S. banks, abandoned their stodgy ways but forgot to replace their stodginess with a culture that was compatible with the regulatory world in which they lived. Does that mean that Europeans are less ethical than Americans? No. I do not believe that. For example, Barclay's was run by an American who fostered a cowboy corporate culture in a British bank; go figure. My point is not to bash Europeans. It is merely to point out that corporate culture matters to stockholders. Temporary profits are-uh-only temporary.

Many non-U.S. corporations have good cultures. As American investors, can we evaluate those cultures? Both disclosure and governance standards are different from U.S. standards. There are fewer independent directors and less stringent disclosure requirements. Some countries have corporate traditions that I might not trust. Italy would be a good example.

In addition, companies headquartered in some countries-France, for example-are hamstrung in their drive toward efficiency because government policies prevent them from closing inefficient plants or from laying off workers. In other countries the impediments to efficiency are more subtle. Governments may either demand that graft be paid (if you do business in, say, Nigeria) or that certain people be taken care of. In either event, efficiency is very difficult to achieve.

I also am more familiar with U.S. GAAP than with International Accounting Standards (IAS). IAS may be just as good. I just don't understand it as well.

For these reasons, I like to invest mostly in companies headquartered in the U.S. and to get my international exposure through their international markets and manufacturing diversification.

Developing Markets

But I would like to invest in some of the developing markets. That is a different dimension from mere international exposure. Developing markets suggest the possibility of more directly tapping the growing middle classes and the growing numbers of creative people in China, India, Brazil, and, increasingly, in Indonesia, Malaysia, Bangladesh, the Philippines and other populous developing countries. But I find that I cannot understand the local companies' disclosures, nor do I trust the managements. Therefore I get exposure to those countries' companies through mutual funds-where I can, through country-specific mutual funds. I have done that with India and China for close to two decades, with generally good results. Stock markets go up and down, but over the long term, I have benefited by this type of exposure. And in each country or region, I try to own more than one fund because past performance is no guide, and I figure one of them will get it right.

A Plug for the Securities and Exchange Commission

The U.S. investor protection system is ahead of the rest of the world. We may find fault with the SEC on many issues. On many issues the SEC may unrealistically believe in an excess of stockholder democracy, for example. Or in the run-up to the financial crisis, it accepted responsibility for the big investment banking firms without having the proper staff and rules to do so. I have been critical of how the SEC treats bank loan loss reserves. But I have worked with all of the major branches of the SEC since the late 1960s. The SEC's commissioners and staff usually are intelligent people who care about investors and protecting them. I like investing in companies that are subject to the SEC's oversight.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.