Rewriting the Rules of Portfolio Diversification

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.