Rewriting the Rules of Portfolio Diversification

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.

Conclusion

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.