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Traditional Benefits Of International Diversification Disappearing

By Austin Lewis

Conventional wisdom suggests that investing in international stocks offers an additional source of diversification to an investor's portfolio. The reasoning is simple enough: stocks of companies in foreign markets are less likely to be affected by the economic factors of other countries. If a U.S. investor owns stock of a foreign company, then that stock is less likely to be impacted by US systematic risk during a downturn in the U.S. economy. This strategy reduces the co-movement between individual investments in a portfolio. Wendy Trevisani (2005), Associate Portfolio Manager of the Thornburg International Value Fund, explains this theory:

"The presumption is that, at any given time, certain regions of the world may be experiencing economic and market performance divergent from the United States. In theory, equity markets in those countries will reflect local economic performance and not be tightly correlated with the U.S. market."

What if there is a flaw in the central component of this argument? Research shows that international cross-correlation coefficients have been rising over the last few decades. In an interview during this year's International Investing Week, Christine Benz (2015) of Morningstar explains why:

"When we look at historical data about correlations, what we see is that they have generally been rising over the past several decades--the correlations between U.S. and foreign stocks…I think this is a pretty intuitive finding. We live in a global world where you've got companies responding to similar forces, and companies themselves are increasingly global. So, they are selling their wares into not just the markets in which they are domiciled, but also into foreign markets. So, it's only natural that things would start coming together as they have."

I observed the cross-correlation coefficients for monthly stock returns of twenty developed markets for two different periods, first from July 1989 to December 2005 (Figure 1), then from January 2006 to December 2010 (Figure 2). The results show that now, after the financial crisis, correlations between U.S. and foreign stock market returns are even higher than previously thought. Figures 1 and 2 show the rise in correlation from the first, pre-crisis period, to the second period, which includes the crisis. In the first period, the average correlation between the U.S. and foreign stock returns was 0.55, while it rose to 0.75 in the second period. The most highly correlated and least correlated countries both rose significantly, going from 0.71 (Singapore) to 0.86 (United Kingdom), and from 0.35 (New Zealand) to 0.62 (Sweden), respectively.

Figure 1: Cross-correlation, monthly country stock returns, 1989-2005

Figure 2: Cross-correlation, monthly country stock returns, 2006-2010

The financial crisis has brought greater insight into just how highly correlated markets are throughout the world. It appears that investing in international equities brings much less diversification to a portfolio than previously thought. A deep recession originating in one country will now strongly affect investments in other countries.

This data can also be used to show how the risk-reward landscape of international investing has changed. As a measure of risk, I computed the standard deviation of average monthly returns for each of the countries in the two sample periods. The results can be seen in Figure 3 and Figure 4, a scatter plot of the risk and reward statistics for each country for the two periods:

Figure 3: International markets, risk and reward 1989-2005

Figure 4: International markets, risk and reward 2006-2010

In the earlier period from 1989 to 2005, there is a clear pattern of risk and reward; investing in those foreign markets that were riskier, whose monthly returns had a higher standard deviation, tended to bring higher returns to a portfolio. In the second period, from 2006 to 2010, there was no such predictability. The returns tended to be more random and there was not as clear an indication that risk came with reward.

So what does this mean for investors?

This data solidifies the observation that as the world becomes more and more globalized, international stocks will offer less and less diversification to one's portfolio. Companies are becoming more global and they all respond to the same forces. The financial crisis showed us just how small the world has become, and as this trend continues, investors will not be able to count on foreign equities as a source of portfolio diversification. It also showed us that investing in riskier foreign markets will not always be met with the reward that an investor would expect.

Works Cited

Chambers, L. (2005). [Interview with Wendy Trevisani]. Phi Kappa Phi Forum, 85(2), 4-5.

Retrieved from EbscoHost.

Stipp, J. (Interviewer) & Benz, C. (Interviewee). (2015). Do Foreign Stocks Really Diversify?

[Interview Transcript]. Retrieved from Morningstar Website:

www.morningstar.com/cover/videocenter.as....