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Tuesday, June 28, 2011

International Diversification Simply Doesn’t Work - Published in the Santa Barbara News Press in April of 2011

When I was a portfolio manager with Wells Fargo, I also served as an analyst, covering certain stocks for the portfolio managers throughout the bank to use for managing client portfolios, etc.  Not long after I joined the bank, I performed an analysis of the model portfolio Wells used at the time as the basis for their stock allocations for most client portfolios. 

The Wells model portfolio included a sizable allocation to international companies, which I found to be of concern.  While most investment advisors these days will tell clients that it is important to own investments from outside the U.S. markets to diversify (reduce potential risks), I have always felt that this was a mistake. 
Through analyzing the Wells model portfolio, I reviewed the sources of revenues for all of the companies included in the portfolio.  What I found was that the U.S.-based companies in the portfolio as a whole had a significant amount of revenues generated from foreign markets.  My conclusion was that, even if you accepted the conventional thinking that every stock portfolio should contain foreign investments, this model portfolio was heavily overweighted internationally, due to the additional international revenues that the U.S. companies were generating.

Some may argue that what matters is not where the revenues come from, but rather where the company is headquartered.  I disagree completely.  The risk and the opportunity reside in the revenue generation potential of the company.  Even though McDonald’s, as an example, is headquartered in the U.S., it only generates about 40% of its revenues here; 60% come from outside the U.S.  One need only watch the fluctuations of McDonald’s stock to see that the performance and the risk in the stock are directly driven from their financial performance, which in turn is a direct result of their revenues and earnings.

Needless to say, the powers that were at the time, were none too happy with me for my research report, and refused to publish it to the other portfolio managers throughout the country.  (Just for the record, Wells is a great company, and I haven’t been there for years, so I don’t know how they manage money these days, and I am sure they do a great job for their clients.) 

My experience with Wells on the issue of international diversification to reduce portfolio risk underscores what I believe to be flawed thinking that is pervasive throughout the industry.  Just about any advisor out there will tell clients that in order to reduce their risk, they need to add international investments to their portfolios.  In fact, there are multiple studies that have been done over the years that appear to prove that owning foreign investments does actually reduce risk.  But what is risk?

Most of us in the investment management field define risk as portfolio volatility—the fluctuation of portfolio values over time around the mean return.  Investors think of risk in an entirely different way—they see risk as the potential for losing money.

If we use the investor’s definition of risk, the benefits (or lack thereof) associated with international diversification are easy to see and understand, from the investor’s point of view.  Diversification is the allocation of assets into various types of investments to reduce overall portfolio risk.  Again, using this definition, portfolio managers typically recommend purchasing international investments to improve diversification, thereby reducing overall portfolio risk.  The idea is that, at times when U.S. investments perform poorly, the international investments will go up, offsetting the losses from the U.S. investments, or will at least not go down as much as the U.S. investments, reducing the overall negative impact on the portfolio.

Investment professionals use what is called correlation to mathematically calculate the relationship between various asset classes, and to “prove” that international diversification works—reduces portfolio risk.  The problem with their “proof” is that they calculate their correlation coefficients, based on historical performance for the various asset classes. 
It is true that, if you use a very long time horizon, and back-test the relationships between U.S. and international assets, the correlation coefficients can show low correlations, meaning that U.S. and international assets do not move in the same direction at the same time, at least by the same amount.  In other words, these calculations appear to show that owning both U.S. and international investments in the same portfolio works—reduces risk.

However, what investors care about, or should care about, is losing money, as discussed above, and not simply reducing portfolio volatility.  Also, while looking at long-term averages might help investment professionals justify international investments, the reality is that it only takes one significant, negative event, such as we had in late 2008/early 2009, to crush an investor’s performance and completely disrupt and possibly delay their retirement plans.

To underscore my point (which is that international diversification doesn’t work), let’s look at some of the most popular international indexes and their returns through the market collapse of 2008 and 2009.  One popular international investment vehicle has been the BRIC countries—Brazil, Russia, India and China.  The Morgan Stanley index that tracks these markets dropped by about two-thirds around the time that Lehman Brothers failed.  During the same time-period the S&P 500 fell by about half (significantly less than the BRIC index).  The EAFE Index (Europe Australia and the Far East) tracks 21 indexes from these markets.  It also fell by about two-thirds during the same time-period; again, substantially more than the S&P 500.  In fact, if we look at just about any index representing almost any foreign equities market outside the U.S., we find the same result—the foreign market declined more than the U.S. equity markets during the same turbulent time-frame. 

This is not what is supposed to happen, if we believe the proponents of international diversification!  What should have happened is that the foreign markets should have gone up, or should have at least performed better than the U.S. markets.  Regardless of whether one defines risk as portfolio volatility, or losing money, diversification simply failed to protect investors from risk.
One could argue that the disruptions in the world financial markets were so extreme, so unexpected, so coordinated, that of course diversification failed to protect portfolios from losses.  If the proponents of international diversification could somehow guarantee us, or at least assure us, that nothing like this will happen again, maybe we could overlook the obvious.  Unfortunately, the world financial markets are forever linked (which is a key reason why back-testing correlation coefficients doesn’t yield usable data), making it much more likely that we will experience more significant market disruptions on a global scale in the future.

Returning to my original position, which was formulated many years ago, I firmly believe that investors gain plenty of international exposure by simply investing in top-quality, U.S. firms that generate significant revenues outside the U.S.  In other words, if an investor wants exposure to a foreign market, buy a U.S. company that does business there, plain and simple.  One need only review the financial filings of companies to see where they are doing business, so the process of evaluating and selecting viable candidates is not difficult or time-consuming.

If you agree with me up to this point, then there can be only one good reason to invest in a non-U.S. company—to make money.  If there is a company in a foreign market that is an outstanding prospect, that has a competitive advantage over its U.S. rivals, has dominant market-share, superior products, management, etc, etc, then, and only then, may it be a possible candidate for investment.  In other words, buying non-U.S. companies simply to diversify is a bad strategy and will not work.  So, unless the foreign company is a better prospect that it U.S. counterparts, there should be no reason to purchase it.

Investors should not take my word for this (or anything else).  Question your advisor.  Ask them why they are recommending foreign investments (if they are).  If they tell you its for diversification, don’t just accept it.  Make the advisor support his or her position and show you a valid reason for their recommendation.  It’s your money!  Unless they can convince you of the merits of each and every recommendation, just say no!

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