At least since Harry Markowitz’s work in the 1950s, diversification has been viewed as the key to an efficient portfolio that minimizes risk for a given expected rate of return. When James Tobin received his Nobel Prize in 1981 – in part for his work on the subject – he summarized portfolio selection theory in the classic fashion: “don’t put all your eggs in one basket.”
Over the years, academicians and market professionals extended this fundamental principle to the global asset universe, highlighting the benefits of going beyond simply holding a broad group of domestic instruments to the idea of international diversification. In the case of equity portfolios, they also observed that people typically hold a smaller share of foreign stocks than simple portfolio selection models prescribe. This gap between actual and model-based optimal allocations of equity portfolios has become known in finance as the equity home bias puzzle.
More recently, however, investors have lamented the diminishing benefits from owning foreign assets. Because swings in key securities markets across countries have become more synchronized, owning foreign assets appears to do less to reduce portfolio risk than it once did. It turns out, however, that – at least in the case of equity portfolios – it is the short-run benefits that have largely disappeared. For long-horizon investors, international diversification still has advantages.
To see why we say this, let’s start by looking at the basic case for diversification. The classic demonstration of the benefits comes from mean-variance analysis – a simple tool to measure the tradeoff an investor faces between the expected return and the risk (measured as the variance of the return) on a portfolio of assets. Provided that two asset classes are not perfectly correlated (that is, their statistical correlation is less than one), holding a mix can reduce risk for a given rate of return.
The following chart illustrates this pattern for a portfolio composed of U.S. stocks (proxied by the S&P500) and stocks from other relatively high-income economies (proxied by the MSCI EAFE index). Including foreign stocks along with U.S. stocks can reduce the overall variance of a portfolio even though the foreign stocks collectively have both a higher variance of returns and a lower average return than their U.S. siblings. For the period from 1980 to 2014, the minimum variance portfolio – that’s the smallest risk you can achieve – has roughly a 13% share outside the United States.
Efficient Portfolio Frontier (based on one-year holding period returns), 1980-2014
Sources: 1980-2013, 2014 MSCI EAFE, 2014 S&P500, and authors’ calculations. Note: Each dot represents the average return and the standard deviation of returns for a portfolio that holds x percent of the S&P500 and (100-x) percent of the MSCI EAFE.
There is a sense in which the share allocated to international equity is fairly small (non-U.S. markets represent more than 40% of the advanced-economy equity universe included in the MSCI World index). The reason is that over the last 35 years, the correlation between the one-year return on the S&P500 and that on the MSCI EAFE was 0.66. The lower the correlation – the further it is from +1 – the greater the potential benefits from international diversification. Indeed, were the correlation -1.0 (“minus one”), all risk in the portfolio could be eliminated (resulting in a synthetic riskless asset).
The problem for international investors is that – at least over short horizons – the correlations across stock markets have risen notably since the start of this century. The following chart shows two-year moving correlations of monthly percent changes in the S&P500 price index with corresponding changes in the other-advanced-economy stock price index (MSCI EAFE) and an emerging market stock price index (MSCI Emerging Markets). While the correlations fluctuate considerably over short intervals, their averages since 2000 are much higher than in the prior decade.
Two-year moving correlations of monthly percent changes in the S&P500 index and the MSCI EAFE and Emerging Markets indexes, 1990-Sep 2015.
Source: Bloomberg. Note: The data on price changes used in this chart do not include equity payouts, so they differ from index returns, but still provide a useful proxy.
Even worse, in recent years, international equity markets appear to have been particularly synchronized at times when the movements were the largest (in either direction). For both the S&P500 and the MSCI EAFE, the minimum returns since 1980 both occurred in 2008, at the height of the Global Financial Crisis. And, in 2009, returns in both markets exceeded 25%. So, precisely when a reduction of risk would seem to be the most valuable – when one market makes a big move up or down – international diversification does not seem to provide it. As a result, the short-run risk-reduction that comes from adding non-U.S. stocks to a diversified U.S. portfolio has fallen.
Going back to the efficient frontier calculations using the S&P500 and the MSCI EAFE annual returns, if we separate the 1980-2014 returns into two periods, pre- and post-2000, we see that the correlation between the S&P500 and MSCI EAFE returns has surged from a relatively low 0.33 to a very high 0.91. As a result, the share of foreign assets in the minimum variance portfolio has plummeted from an estimated 18% of the total to less than 5%!
Fortunately, there is still good news for devotees (like us) of international stock diversification. The reason is that the correlations we’ve used (and that are commonly employed) for these comparisons are short term – based on one-year holding periods. However, research by market professionals shows that country stock markets are less likely to move in unison over long periods of time. So, if you are a buy-and-hold investor – as economists typically advise (see, for example, Burton Malkiel’s classic A Random Walk Down Wall Street) – then the traditional benefits of international diversification persist: you can still lower risk for a given rate of return.
Why might cross-market correlations have risen more over short horizons than over long ones? [1] Presumably, increased global economic and financial market integration – the powerful trends that we highlighted in an earlier post – means greater synchronization. But, integration can influence equity prices either through common swings in the discount rate or through shared movements in the drivers of company cash flow. Liquidity shocks move the discount rate considerably for short periods. Similarly, greater business cycle synchronization leads to higher short-run correlation of cash flows. However, our casual impression is that cash flow developments are more persistent than discount rate news, because they depend relatively more on enduring phenomena like trade flows, the rate of technological progress and changing demographic patterns. So, evidence that international diversification benefits have shrunk over short horizons suggests that globally common discount rate shocks (like the Great Financial Crisis) have become more important since the late 1990s, while a continued role for country-specific factors influencing corporate cash flows could account for longer-term diversification opportunities.
Very recent research suggests that in the case of bonds – unlike stocks – even the long-run benefits from international diversification have receded. Like stocks, bond returns depend on changes in both the discount rate and fundamentals. And, like stocks, the short-run correlation across countries has gone up. But unlike stocks, changes in bond fundamentals are usually dominated by movements in inflation expectations. And, because many countries now successfully target low inflation, idiosyncratic inflation volatility that created the opportunity for long-run diversification in the past has fallen. Put differently, since inflation is more volatile when it is high, there will be more country-specific variation when inflation rates differ significantly across countries. This, in turn, creates more idiosyncratic movement in inflation expectations, giving rise to a potential for investors to hedge. With the broad adoption of inflation targeting, inflation expectations no longer move around as much (see our earlier post here). As a result, the potential benefits from holding foreign bonds are now lower.
So, what’s the bottom line? People still display “home bias,” preferring stocks issued by companies registered in their home country even when they can obtain the same expected return at lower risk through international diversification. While global financial integration probably has diminished short-term diversification benefits, the long-term benefits are still there. At least for equity investors, it’s a good idea to venture abroad.
[1] Our comments here and the following paragraph are based on Viceira, Luis M., Wang, Kevin, and Zhou, John, 2015, “Long Horizon International Portfolio Diversification Across Stocks and Bonds,” work in progress, Harvard Business School.