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Does Investing Internationally Still Diversify Your Portfolio

Does it make sense to invest in international stocks when the tracks on which domestic and foreign markets run seem to parallel each other more and more all the time?

 

The answer to that question depends upon how one breaks down the markets and what time periods he considers.  We talk about "international stocks" as if they are some amorphous, one-dimensional market when, in fact, there are notable distinctions among the correlations between different foreign markets and the U.S. market, and these correlations change over time.

 

For now, though, let's consider an array of mutual funds popularly used by financial advisors seeking foreign exposure.  Funds like First Eagle Overseas, Vanguard International Value, Dodge & Cox International Stock, Janus Overseas, American Funds Euro Pacific A Shares and T. Rowe Price International Stock serve as a group of frequently-used funds most advisors would characterize as "international."

 

When broken down into blend, value and growth funds, we see varying correlations during the three-year period March 1, 2002 through February 28, 2005 with the U.S. market, as represented by the S&P 500 Index, the Barra Large Cap Value Index, and the Barra Large Cap Growth Index, respectively.  What is "correlation?"  Correlation is a statistical technique that shows to what degree pairs of variables are related and is expressed by a number between -1.0 and +1.0.  The closer a "correlation coefficient" is to +1, the higher the positive correlation.  The closer to -1, the higher the negative correlation, meaning it moves opposite.  If it's close to 0, then there's no relationship between the variables.  An investment portfolio becomes better diversified as the correlations among its assets move toward zero.

 

In the case of our international value funds (see Chart #1),

 

CHART 1

 

 

1

2

3

4

5

6

7

1

Barra Large Cap Value

-

0.79

0.92

0.83

0.85

0.91

0.86

2

First Eagle Overseas A

0.79

-

0.90

0.89

0.82

0.85

0.79

3

Oakmark International I

0.92

0.90

-

0.93

0.91

0.95

0.89

4

Oakmark International Small Cap I

0.83

0.89

0.93

-

0.91

0.91

0.83

5

Tweedy, Browne Global Value

0.85

0.82

0.91

0.91

-

0.90

0.83

6

Vanguard International Value

0.91

0.85

0.95

0.91

0.90

-

0.88

7

Longleaf Partners International

0.86

0.79

0.89

0.83

0.83

0.88

-

 

correlations range from a low of .79 (First Eagle Overseas) to a high of .92 (Oakmark International).  For international growth funds (see Chart #2),

 

CHART 2

 

 

1

2

3

4

5

6

7

8

1

Barra Large Cap Value

-

0.82

0.77

0.75

0.77

0.63

0.85

0.85

2

American Funds EuroPac A

0.82

-

0.96

0.95

0.94

0.90

0.99

0.98

3

Artisan International Inv.

0.77

0.96

-

0.91

0.88

0.91

0.97

0.96

4

Harbor International Growth

0.75

0.95

0.91

-

0.91

0.88

0.94

0.94

5

Janus Overseas

0.77

0.94

0.88

0.91

-

0.87

0.92

0.93

6

Columbia Acorn Int. Sel. Z

0.63

0.90

0.91

0.88

0.87

-

0.89

0.88

7

T. Rowe Price Intl. Stock

0.85

0.99

0.97

0.94

0.92

0.89

-

0.99

8

Vanguard Intl. Growth

0.85

0.98

0.96

0.94

0.93

0.88

0.99

-

 

correlations range from .75 (Harbor International Growth) to .85 (T. Rowe Price International Stock and Vanguard International Growth).  And, when it comes to blend funds (see Chart #3),

 

CHART 3

 

 

1

2

3

4

5

6

7

8

1

Standard & Poor’s 500

-

0.81

0.88

0.91

0.90

0.85

0.92

0.82

2

Julius Baer Intl. Equity I

0.81

-

0.90

0.93

0.92

0.94

0.94

0.84

3

Dodge & Cox Intl. Stock

0.88

0.90

-

0.96

0.94

0.89

0.94

0.91

4

Templeton Inst. Foreign Eq.

0.91

0.93

0.96

-

0.97

0.91

0.97

0.88

5

Harbor Intl. Instl.

0.90

0.92

0.94

0.97

-

0.90

0.96

0.87

6

Janus Overseas

0.85

0.94

0.89

0.91

0.90

-

0.92

0.84

7

T. Rowe Price Intl. Stock

0.92

0.94

0.94

0.97

0.96

0.92

-

0.88

8

Tweedy, Browne Glob Val

0.82

0.84

0.91

0.88

0.87

0.84

0.88

-

 

we see the very highest correlations.  Julius Baer International Equity does the best job of distinguishing itself from U.S. markets with a low of .81; and from our limited sample, T. Rowe Price International Stock correlates the most with a .92 measure.  When one analyzes the charts a step further, it becomes evident that there is an even higher correlation among the funds themselves.  Diversification is not achieved simply by buying additional international funds.

 

Although we speak of low and high correlations, the above correlations are all high by historical standards.  Many investment experts believe the correlations have increased because of two major factors:  the first is that we are truly becoming a global market.  After all, what is the difference between Hershey’s and Nestle?  Ford sells as many cars overseas as it does in the U.S., etc., etc.  The second major reason is that we now only have four major currencies:  the U.S. Dollar, the Euro, the Pound and the Yen.  Prior to the formation of the Euro from twelve European countries which all had their own currencies, the world traded its goods and its stocks in many different currencies which were not typically moving in the same direction all at once.  Prior to 1995, international funds usually had a correlation of .50 or less with U.S. indices and each other.  Back then, this helped to diversify portfolios.  Furthermore, a study of foreign vs. U.S. stock returns and market correlations published in the Federal Reserve Bank of New York's March, 2002 volume of Current Issues in Economics and Finance ("Should U.S. Investors Hold Foreign Stocks") shows that correlations between U.S. equities and those of specific countries between 1976 and 1999 ranged from a low of 0.05 (Argentina) to a high of 0.71 (Canada).  In other words, the highest correlation between the U.S. and any individual foreign market during 1976-99 was lower than today's lowest inter-market correlations.

 

All of this means that, with correlations ranging from the mid-70s to the low 90s in recent years, if one is investing in international stock funds for reasons of diversification, he is getting less of it than at any time in recent history.

 

What about currency plays and distressed stocks?  Investing in international stock funds to take advantage of a declining dollar and its salutary effect on the value of one's holdings is a valid investment strategy but it's not the same as establishing a permanent asset category in client portfolios to provide diversification opportunities.  As for distressed stocks, they exist everywhere.  The U.S. market represents only half of the world's investment opportunities so one might very well go outside the U.S. to exercise one's stock-picking strategies.  But neither is this a diversification strategy.

 

The bottom line: International stock funds today offer relatively little attraction as a diversification vehicle.  In fact, at Legend Financial Advisors, Inc.® we no longer use international funds as a separate asset class.  We treat it as part of our domestic allocation.  If it walks like a duck, and quacks like a duck, then we treat it like a duck.



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