June 1, 2001

Small World

From an investor's standpoint, Paris, Texas, and t

For years, proponents of portfolio diversification have trumpeted the merits of global investing. The argument was simple: Adding international stocks to a domestic equity allocation gives you exposure to new investment opportunities as well as markets whose movements may not be correlated to those of the U.S. But many experts are now questioning this premise. "I am not persuaded that international funds are a necessary component of an investor's portfolio," maintains John Bogle, chairman emeritus of the Vanguard Group.

After the huge upsurge in global investing in the early 1990s, it's easy to see why U.S. investors--especially those concentrating on large-cap stocks--have become frustrated with foreign markets more recently. Global bourses have failed to keep pace with the Standard & Poor's 500-stock index even as their volatility increased. Emerging economies have fared even worse, faltering under the strain of fiscal crises in Latin America, Asia, and Eastern Europe. And while returns on overseas stocks tended not to correlate well with those in the U.S. when Wall Street was in a bull market, they did follow America's lead in bear market periods--when investors need diversification the most.

Despite these drawbacks, many international investment fans insist that in many cases, global equities still belong in a well-diversified portfolio. Sure, they concede, stock markets have become more linked. The advent of the Internet, for instance, has made it easier for investors to get information on stocks that trade overseas, and has given foreign investors more data on U.S. markets. And the advent of the euro, a currency that is destined to join the largest economies in Europe, has undoubtedly caused Continental bourses to move more in lockstep.

But correlations among asset classes are still notoriously unstable, making it difficult to ascertain whether the recent appearance of convergence is merely an optical illusion. As a result, the same forces that made international stocks such a compelling buy in the two decades prior to 1990 could reemerge, making global diversification a more rewarding experience than it was over the past decade. According to William Bernstein, author of The Intelligent Asset Allocator (McGraw-Hill, 2000), "there is little evidence to support the notion of an increasing international market correlation resulting from a globalizing economy."

Proponents of global investing point out that the simplest benefit of the approach arises from the increase in the number of securities available for invest

While Europe Sleeps,

U.S. Arbs Buy

Imagine this: Wall Street rallies strongly in the last hour of trading, long after European markets have closed. But domestically traded international mutual funds settle on the close of the U.S. market, based on the value of the underlying international shares that stopped trading hours before. Therefore, after a particularly strong day in the U.S., a vigilant trader can buy an international fund today, knowing that there is a very high chance of the overseas market rallying tomorrow.

Industry sources say that more than $1 billion is committed to this strategy, dubbed time zone arbitrage. But the strategy has repercussions. Detractors say time zone arbs can hurt long-term investors by requiring fund managers to trade frequently and hold excess cash to meet redemptions. Indeed, many fund families frown on frequent trading within funds and can impose high fees for short-term speculation. Because time zone arbitrage generates short-term capital gains for all investors, it is wise to ask fund operators if they allow for such trading.

ment. This is especially true for active strategies. For example, a manager who focuses on large-cap value stocks will have fewer than 1,000 issues to choose from in the U.S. By broadening the search across regions, the opportunity set more than doubles.

The advantages of global investing appear to increase as you move into small-cap stocks, argues Robert Treich, portfolio manager for the Pictet International Small Companies Fund. "Large- cap European stocks are simply too correlated to U.S. markets to add any benefit to a domestic portfolio," he says. "The institutional equity marketplace in Europe is much less developed than in the U.S., and brokerage firms and investment banks that are based in the area tend to concentrate on large-cap stocks," Treich notes. "As a result, many of the small companies in the EAFE [Europe, Australasia, and Far East] index are not covered by analysts. The result is a great environment for stock pickers."

Treich's view seems to have some merit. According to S&P, small-cap international mutual funds have generated a median return of 17.5% over the last three years, compared with minus 8.9% for the HSBC World ex-US Smaller Companies Index. What's more, over 95% of all funds beat the benchmark.

The numbers are less compelling over the last twelve months, as the benchmark's return of -21% has exceeded that of the active funds by about nine percentage points. Still, Treich remains sanguine. "There is significant pressure on the larger firms in Europe to cut costs. As a result, one of the biggest trends is outsourcing in such areas as security, catering, and information technology. This should benefit smaller companies, especially in the service sector."

Even with the success of active management abroad, questions still remain. For one, there's a profound lack of data at the index level, even for developed markets. "The most reliable indices go back, perhaps, 10 years, so it is quite difficult to determine the characteristics of small-cap international stocks," says Treich. "As a result, potential investors must look beyond index returns, and recognize that a good portion of their return will come from the manager's stock selection skills."

Of course, there are plenty of investors who see a benefit from investing in large-cap international stocks in established markets. "Anything that is less than perfectly correlated has a place in a diversified portfolio," says John Christopherson, a research fellow at Frank Russell Company. "It is ludicrous to think intelligence and productivity are exclusive to U.S.-based companies," Christopherson argues. "Investors interested in making money should focus on identifying the best companies at the best price, regardless of national origin."

The Currency Question

Another challenge to international investing is the effect of currency fluctuations on returns. Ever since the demise of the Bretton Woods agreement in 1972, which marked the end of the U.S. gold standard, the dollar has lost significant value. And because a falling dollar translates into higher valuations for non-U.S. assets, the dollar's downtrend served to increase the returns of global equities for much of the 1970s and 1980s. The result of the depreciating dollar explains much of the excess returns generated from international stocks during that period.

Of course, over very long periods currency fluctuations are a zero-sum game. But shorter time frames can be affected significantly by changes in foreign exchange rates. For example, in 2000 Morgan Stanley Capital International's EAFE index was off 14.2%, but most of the decline was from currency movements. If the currency risk were fully hedged, the index would have fallen less than 5%. In contrast, in 1998 the EAFE rose 20%, but a fully hedged portfolio would have gained only 14%.

Mutual funds have the option of hedging against currency fluctuations. But few try to profit from currency swings. For example, Invesco Funds Group, a Denver-based mutual fund family with $48 billion in assets, avoids hedging altogether. Tweedy, Browne Company, a $350 million global value manager, takes the opposite tack; it fully hedges all its foreign holdings into U.S. dollars. Tweedy Browne's stated philosophy is simple: "We can read a company's balance sheet but we cannot read a country's balance sheet."

The question poised by currencies, though, is not related to the short-term effects. A much bigger issue is whether the U.S. dollar's decline 20 years ago is an event not likely to be repeated. If that is the case, the very period that supports the notion of international investing could be a one-time event. "With the fall of communism and the global integration of economies, the investing results of 30 years ago are largely irrelevant," says Christopherson. "And due to the globalization of trade, countries and even regions are no longer a valid explanatory variable of stock returns. Since the fall of communism, opportunities for diversification among European countries have diminished significantly. We expect the same thing to occur between other regions as globalization continues to march forward."

As it turns out, the biggest driver of globalization is cross-border investing. "As boundaries between countries become increasingly fuzzy, investors have less compunction about committing assets outside of their home markets," says Christopherson. "With the advent of the euro, information exchange across borders has increased as well."

If investing by region has become an ineffective method of diversifying, there are other alternatives. Correlations between industries, for example, have not been significantly affected by the advent of the euro. Since diversification opportunities abound at the industry level, many of the leading firms have developed well-defined, international industry classifications.

Last year, Frank Russell and FTSE, a global index provider, announced a strategic alliance to strengthen the global profile of both companies' index products. The first stage of the collaboration is adoption of the FTSE global classification system in Russell's domestic indices. Eventually, the use of FTSE industry sectors will provide a classification system that is not specific to a particular market, but is truly global in nature and will allow for sector investment across national borders. "What we will eventually see," says Christopherson, "are exchange traded funds based on a particular industry that will contain all stocks in that sector everywhere in the world. The goal of the venture is to allow for investment in segmented groups of equities that are non-correlated in order to construct more efficient portfolios."

A similar venture between Morgan Stanley Capital International and S&P aims to promote a jointly developed global industry classification standard. MSCI launched its "all country sectors" index in January in response to increasing demand from the investment community for global sector analysis. According to a company spokesman, 63% of European assets are now allocated on a sector basis, up from 22% in 1997. Institutional investors in the U.S. also seem to be jumping on the bandwagon.

How long it will take for this trend to filter down to advisors and planners is anyone's guess. The change seems inevitable, though, given the large number of inter-industry mergers across national borders. Consider DaimlerChrysler, which competes with Ford and General Motors, not to mention Toyota. Most investors would rather view DaimlerChrysler as a global automobile manufacturer, rather than a large-cap European stock.

Fighting Home Bias

Even with the dizzying array of international investing opportunities, there are still some who shun global diversification altogether. Merrill Lynch recently reduced its recommended foreign stock allocation for its high-net-worth clients from 35% to 5%. J.P. Morgan Chase similarly lowered its allocation guidelines to 10% from 15%. Even academia has gotten in the fray; a December 1999, Journal of Finance article (Vihang Errunza, Ked Hogan, and Mao-Wei Hung, "Can the Gains from International Diversification be Achieved Without Trading Abroad?") concluded that the incremental gains from international diversification beyond what can be obtained domestically have diminished over time in a way consistent with changes in country barriers.

Such arguments are not as difficult to sell as one might think. A well-known predilection called home bias describes the tendency of investors to limit their holdings to stocks in their own backyard. In 1999, U.S. investors placed 98% of their equity portfolios in domestic equities, even though domestic markets only account for 45% of the total world market capitalization. Investors in Great Britain, Japan, and other developed nations exhibit similar behavior.

Many explanations have been offered to explain why investors like to stay close to home. But foreign exchange risk, hefty trading costs, and less-than-perfect access to information fail to account for the tendency of market participants to invest not just within their own borders, but in their backyards. A study of domestic portfolios of U.S. money managers, for example, shows a heavy bias toward firms located near their offices. Similarly, a recent survey found that employer stock makes up one-third or more of total 401(k) assets--a form of home bias that is not good for anyone.

"Single stock concentration is a real problem with many individuals," says Lane Carrick, a registered investment advisor in Tennessee. "People commonly overstate their knowledge about companies that they work for or that are close to them geographically. The same can be said at the country level, where a false sense of security toward one's home markets often results in sub-optimal portfolio construction."

Carrick believes that when investors tilt toward their backyard, they take on more risk by diversifying less broadly. "There are a myriad of investment opportunities in alternative strategies, such as hedge funds and managed futures, as well as overseas," he says. "Taking the road less traveled holds significant benefits for investors." Although the chorus of global investing skeptics has grown louder, you still need to think twice before concluding that the safest place to keep all a client's assets is at home.

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