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%.