Diversification is among the most elementary tenets of investing basics. It’s what every financial advisor learns during the first week on the job. In turn, these investing fundamentals are transmitted to others.
For instance, commonly spoken words of advice like “Don’t put your eggs in one basket” and “Be sure to hedge your risk” are routinely given by the vast majority of financial advisors to their clients. This is true despite major philosophical differences within the financial services industry itself about the best way to invest.
Here’s the problem: traditional techniques for obtaining equity portfolio diversification have been turned upside down as a result of monumental changes in global financial markets. What does it mean? The old-fashioned approach toward portfolio diversification of spreading assets across global regions is losing its luster.
Global Revenue Sources
The impact of globalization on equity investors and how it’s changed the rules for obtaining diversification cannot be negated or ignored.
Before the financial crisis in 2008, foreign revenues for S&P 500 companies topped at 48%, according to data from S&P Dow Jones Indices. Instead of dropping off a cliff, foreign revenues generated since then have stayed consistently high, stabilizing near 46%. Put another way, nearly half of S&P 500 revenues are coming from international sources!
A similar trend can be seen in other major developed markets.
For example, the FTSE 100 — the principal benchmark for U.K. stocks — had just 23% of its corporate revenue coming from domestic sources in 2013. That means an advisor or investor buying a single-country ETF focused on the U.K. isn’t getting as much exposure to the U.K. as they may think or even want. In reality, a concentrated bet on a single-country equity market that looks and feels like a domestic play may end up being a global investment because of overseas revenue sources.
Limited Regional Effects
The rulebook for how to achieve authentic equity diversification is being rewritten. And that’s largely because of the previously mentioned impact of increasing foreign revenues.
A study by Morningstar from 2000–2014 examined regional versus sector factors across 23 developed and 23 emerging stock markets. The data revealed considerable proof that industry factors are far more important than a company’s geographic location in determining differences in earnings and dividend growth. “We find that industry factors alone explain more than 50% of variability in the growth across developed countries,” said Philip Straehl, a portfolio manager with Morningstar.
What this means is that advisors who invest in broadly diversified international ETFs like the iShares MSCI EAFE (EFA) or the Vanguard Total International Stock Fund (VXUS) may be getting less international diversification than expected.
The fact that some international companies within these ETFs have become more global in nature changes everything. Why? Because people invest in international stocks with the expectation that corporate growth revenue in those countries will be meaningfully different compared to companies based in their homeland. But as overseas companies become invariably more global, the benefits of broad diversification across regions are diluted, pushing sector diversification to the spotlight.
Countries and Sectors
The dynamics of equity diversification devolve even further when single-country ETFs are used. Because most countries outside of the U.S. lack broadly diversified economies, most investments made in stocks from individual countries end up being sector plays.
Over 62% of the iShares MSCI South Africa ETF (EZA) is concentrated in just two equity sectors: consumer discretionary and financials. Similarly, more than half of the $3.2 billion iShares MSCI Brazil ETF (EWZ) is committed to consumer staples and financial stocks. Likewise, just over 57% of the Market Vectors Russia ETF (RSX) is invested in just two industries: energy and materials. As a result, the drivers behind future market returns for each of these countries will largely be influenced by the performance of the respective industries to which they have the largest exposure.
A closer look at Russia illustrates the high degree of sector influence on performance. Roughly 40% of RSX’s sector exposure is to energy stocks like Gazprom and Lukoil. Meanwhile, Brent crude oil prices have crashed around 56% over the past five years while RSX has followed a similar path by crashing 50%. The lesson is that whatever sector forces dominate your country ETF will directly impact performance.
This can be both good and bad. It’s good if you understand that investing in single-country ETFs is nothing more than a sector play in most cases. On the other hand, it can be bad if those particular industry sectors are underperforming and thereby dragging down returns.
Location Isn’t Everything
Although advisors have historically sought diversification by allocating away from their domestic or local stock market into international markets, the benefits of regional diversification, according to Morningstar’s study, are muted. This is particularly true in developed markets like Canada, Germany, Italy, Japan, Switzerland, the U.K. and U.S.
“The dominance of industry effects supports the view that as firms become more global, the importance of a firm’s location as a determinant of growth diminishes, “said Straehl. He adds the idea that investors should reduce their home-country bias for diversification reasons are “weakened arguments.”
Thus, advisors need to look beyond geography. They also need to rethink the strategies they’ve grown accustomed to and why those methods might be restricting portfolio diversification rather than increasing it.
Successful investing is a dynamic exercise filled with constant changes and surprises. Today, the rules of equity diversification have dramatically changed because of mega trends like economic globalization. And because of these changes, traditional methods for obtaining equity portfolio diversification by simply spreading assets across global regions are becoming less effective.
In some circles, sector investing has long been decried as a speculative activity that prudent investors should absolutely avoid. But recent data suggests that sector factors, not where a company is based, are the primary drivers of dividends and earnings growth.
The final takeaway is that advisors should understand that diversification across industry sectors is far more important in today’s global climate than blindly investing in stocks on a regional basis.