- Markets are more correlated in the short term but strongly diverge in the long term.
- Currency movements further fuel international divergence.
- Being overweight a certain market or currency means carrying additional risks that could be removed by international diversification.
One issue that is more often off than on investors’ minds is international diversification. Historically, cross-country equity correlations have been far from perfect but they are becoming more correlated in recent times. The higher correlation is not a reason to shun international diversification.
Lower Long Term Correlation of International Markets
The long term correlation among international markets is lower than the short term due to several reasons. The first one is that even if in the short term the global integration of capital markets makes it look like they are correlated, in the longer term structural influences prevail. The following two figures show the difference between short and long term correlation.
The difference among the above indexes in one year is only 10% with the AEX being the worst performer. This small difference makes investors forget about international diversification. But in the long term things are completely different.
The below cumulative GDP growth chart shows how countries experience different growth levels in longer periods. The UK and the US have grown 50% faster than the Netherlands while Brazil grew 100% faster than the US in the period from 2000 to 2015.
The above long term factors also lower the risk of a portfolio in a long term and are important factors to think about when investing. But, even if the benefits of portfolio diversification are clear in the long term, investors stick to their domicile markets. This phenomenon is called the equity home bias puzzle.
Equity Home Bias Puzzle
An interesting feature in the international markets is the home bias. It describes the tendency to invest the largest part of one’s portfolio in domestic securities despite the benefits of international diversification. University of Chicago researchers, Moskowitz and Coval have found that specifically US investment managers exhibit a strong preference for locally headquartered firms that often create asset pricing anomalies. A Morningstar research in 2013 found out that US mutual fund investors keep only 27% of their equity allocation in not US domiciled funds while the Equities not domiciled in the United States accounted for 51% of the global equity market. It is logical that investors prefer the familiar but each investor should assess its own exposure to a certain currency and evaluate his long term risks related to that exposure.
The Strength of the Dollar
Being overweight one market means betting on the success of that currency or market in relation to other markets and currencies. Therefore, such an overweight investor has to assess potential international macroeconomic influences on his portfolio. Such long term economic shifts are very difficult to time and therefore considered betting. US investors have had a great investing performance in the last few years with Europe starting quantitative easing, commodities, that are the main wealth resource of emerging markets faltering and China experiencing a soft landing. But, the below figure that compares the US dollar to a basket of foreign currencies shows how risky an overweight currency strategy can be.
The main idea behind this article is to give food for thought. International diversification might not be relevant in the short term but in the longer term it can provide certain benefits. There are various ways of being internationally diversified, through buying different indices or by buying stocks of the same sector that have a different geographic focus. A clear example for that are utilities, they provide relatively stable returns and dividends and when dispersed internationally can lower the volatility of a portfolio.