On the merits of international diversification

Moman advicing man
11-09-15 9:12 | Markets and investments | Fredrik Wilander

In the aftermath of the financial crisis, proponents of international diversification felt the heat. As markets fell in tandem, the strategy of spreading equity investments globally did not prevent negative returns. Rightly, many equity markets fared a lot better in 2008 than the Nordic markets, but investors had likely hoped for more. The merits of international diversification are however there, but emerge not in any given month, quarter or year. Rather, it is over time that they become clear.

 
Towards the end of 2007, world financial markets had already started to shiver, but were still far from bottoming. Commodity prices were still high, and the BRICs (Brazil, Russia, India and China) were investor favorites. For Nordic investors, this was coupled with a love for the domestic market, a sizeable so-called home-bias. It was very hard to get Nordic investors to accept the advice of also allocating some capital to the more “boring” equity regions like USA or Japan. Especially the latter had also a miserable track record since the peak valuations in the early 90s.
Now, some eights year later, it is not the investor favorites of 2007 that have emerged as the winners. It is actually the boring regions that have prevailed. The difference in returns between the best and worst region (North America vs. Emerging Markets), is over 100 %-points. 

The investor favorites from 2007 not the winners of today 


Cliff Asness at the US-based asset manager AQR in 2011 wrote an article in Financial Analysts Journal titled International Diversification Works (Eventually). Here he put forward a simple and intuitive point. In the short-run, relative returns are to a large extent driven by risk appetite. During market panics, return correlations between risky assets rise. This prevents diversification benefits to play out. But over time, relative returns are to a larger extent driven by differences in economic fundamentals. And then, international diversification excels.
There are in my opinion two related reasons for international diversification. The graph illustrates one of these two points. It is at any given point in time incredibly difficult to pick the winner (or loser) region or sector in the coming 5-10 years. Few would have picked USA and Japan over Emerging Markets in 2007.  It is no easier task today. Therefore, the risk associated with betting everything on one horse is simply quite large, both the risk of betting on the wrong one as well as the risk of missing out on the winner. However, in investing as opposed to horse betting, we can actually bet a bit on all horses. The second reason was a case in point for Norway and their sovereign wealth fund this year. It is exactly at the time when a country’s long-term outlook and fundamentals worsens that the benefits of investing globally emerge. The outlook for Norway Inc. is naturally a bit worse with oil prices at $50 per barrel than at $100. Less money will flow to both the Norwegian state and into the fund. But, the weaker economic outlook also means that the currency depreciates, lifting the value of holdings and cash-flows from abroad. And, as for most other countries, it is from abroad that Norway buys a lot of goods and services. Today, as well as at that future point in time when the oil is no longer there. International diversification is thus also a hedge towards long-term poorer prospects for the domestic economy, which may affect future labor income as well as house prices, important assets on the household balance sheet.

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