Diminished gains from international portfolio diversification

03Jul07

The international equity markets are hot. The International ETF Performance Report from Bespoke Investment Group demonstrates this. Any number of markets are substantially outperforming the U.S. market year-to-date. The widespread interest in (and launch of) any number of foreign market ETFs is another indication of foreign market dominance.

Undoubtedly some of the current interest in the foreign markets represents a measure of ‘return chasing.’ Indeed we should expect nothing less. Another part is also driven by the longer term trend of domestic investors diversifying their portfolios globally.

We have previously noted how international markets could serve as a ‘natural hedge’ for domestic investors. This concept is largely intuitive, but is decidedly not quantitative in nature. There is no simple answer as to how much one should allocate globally.

We recently came across a nice summary of an academic research paper on this very topic that concludes that the benefits of international diversification are indeed declining over time. Les Picker writing at the NBER Digest* looks at a NBER Working Paper, “Is the International Diversification Potential Diminishing? Foreign Equity Inside and Outside the U.S.” by Karen Lewis.

From the summary of the paper’s findings:

These (foreign portfolio diversification) trends could be summarized as follows: first, international equity markets have become more highly correlated. Second, foreign stocks inside the United States have become more correlated with the U.S. market over time. As a consequence of these trends, the attainable diversification from participating in foreign markets is declining, whether the investor holds foreign stocks inside or outside the United States.

Measuring the precise benefit of diversification is always problematic. These calculations are always highly parameter-dependent. Diversification is by no means a panacea. It is already well-known that in times of crisis (economic or financial) that most markets correlations tend to one. That is, their returns become more highly correlated as liquidity dries up.

Is this altogether bad news for investors? Not really. To use an example, we don’t really worry about the correlation between domestic large caps and small caps very much. We recognize that there is some diversification benefit by investing in both asset classes, in spite of their high correlation. The same is the case for domestic and international stocks. The precise amount of diversification is less important than the fact that there is some benefit from holding a globally diversified equity portfolio.

*You can find more paper summaries at the NBER Digest Online.

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