From the July 2008 issue of Wealth Manager Web • Subscribe!

July 1, 2008

Small Steps in the Right Direction.

One way to hedge against the recessionary and inflationary fears mounting in the U.S. markets is through international diversification. In fact, data from the Advisor Perspectives universe of approximately $50 billion of assets managed by RIAs serving HNW and UHNW clients show that many of these advisors have been doing exactly that.

Over the last year, according to the Advisor Perspectives' data, these advisors have increased their non-U.S. exposure from 10.1 percent to 13.0 percent of total assets (see chart below right)-an increase of nearly 30 percent. Equally significant is the 7.9 percent drop in exposure to the U.S. markets-from 71.0 percent to 64.4 percent. As we noted in last month's column, advisors also have bulked up their cash positions, increasing them from 8.4 percent to 10.7 percent of total assets.

Most of the increase in non-U.S. holdings has gone into emerging markets. In fact, allocations to developed non-US equities decreased from 88.2 percent to 78.5 percent of non-U.S. assets, while allocations to equities of emerging non-U.S. equities increased from 8.6 percent to 18.1 percent of the total. Allocations to non-U.S. bonds-both developed and emerging-have held constant at just over 3 percent of non-U.S. assets.

This shift in assets was set in motion by the sub-prime crisis, which heightened fears about the stability of the U.S. financial markets. Some of the developed markets, such as the United Kingdom, face parallel threats of housing bubbles combined with overextended consumer borrowing, and their economies do not offer diversification benefits. Other developed economies are too tightly coupled to the U.S. market to offer sufficient diversification. Correlations between broad-based U.S. market indices and world market indices have increased substantially over the last several years. From 1978 to 2006 the correlation between the MSCI U.S. index and the MSCI World index (ex- U.S.) was 0.58, but this has risen to 0.83 since 2006, with the increase mostly in the developed economies. This is why advisors have looked to the less correlated emerging markets to diversify.

Still, non-U.S. exposure of 13.0 percent is still relatively small. Dartmouth Professor Ken French, in his recently published study "The Cost of Active Investing", notes that U.S. investors as a whole hold 27.2 percent of their assets in non-U.S. securities. His data includes institutional investors, who have been much more aggressive in their non-U.S. diversification. Given the fact that the U.S markets represent approximately 42 percent of world market capitalization-implying that, even at 27.2 percent, U.S. investors still have a way to go to achieve full diversification-we asked French about the data. From an academic standpoint, he says there are legitimate reasons for investors to have a preference for their local markets, such as concerns about political risks, taxes, and transaction costs in other countries that may not be well understood or quantifiable. In addition, he cites "consumption risk" as a factor that keeps investments in local markets. Because investors prefer assets that are tied to their own levels of consumption, U.S. investors will favor companies that make products for the U.S. markets.

For an example of how these circumstances play out in "real life," we checked with noted advisor Harold Evensky, president of Evensky and Katz in Coral Gables, Fla., who says he has been increasing his clients' exposure to non-U.S. markets over the last several years. However, Evensky finds that it has taken a while for clients to get comfortable with increased levels of non-U.S. exposure. Evensky has begun looking at "frontier markets"-smaller, less developed economies as compared to emerging markets. These include countries like Namibia, Bangladesh and Kazakhstan. "The asset class makes a lot of sense," Evensky says, but he has yet to invest there.

It is surprising that assets of high- and ultra-high-net-worth individual investors are not nearly as broadly diversified in non-U.S. markets as those of institutional investors. With the U.S. now accounting for just 5 percent of the world's population and approximately 25 percent of the world's GDP, it hardly seems rational for investors to allocate 87 percent of assets to the U.S. markets. If advisors accept the belief that the U.S. will play an increasingly smaller role in the world's economy over the coming decades, then a logical way to achieve superior long-term performance is to become more diversified in developed, emerging and even those frontier markets.

Robert Huebscher is CEO of Advisor Perspectives (www.advisorperspectives.com), a free online database and weekly newsletter for wealth managers and financial advisors. He can be reached at rhuebscher@advisorperspectives.com.

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