A reader recently shared an experience with an advisor who told him you don't need to diversify internationally, with all the "risks" that it entails. Instead, U.S. multinationals provided all the diversification benefits you needed. And you can get the diversification benefit by investing in a large-cap fund like one that replicates the S&P 500 Index. This is an often repeated statement. However, it's also an example of the truth in the statement that "It isn't what an investor doesn't know that gets him in trouble, but what he knows for sure but isn't true."
Before considering the evidence, let's look at the "logic" that leads investors to draw this conclusion. Many large companies are global giants -- selling their products and services all over the world. Clearly, their earnings will be impacted by global conditions. Thus, if you invest in these large international companies, you get all the diversification you need. As you'll see, such "logic" can be wrong. The way to test the logic is to look at the historical correlations of returns.
We begin our look at the data by looking at the correlation of the S&P 500 to the MSCI EAFE Index. For the period 1970-2010, the annual correlation was 0.66. Thus, while some of the returns of the MSCI EAFE were explained by the returns of the S&P 500, the correlations were certainly far from perfect. Thus, investing in international large-cap stocks provided some important diversification benefits. Consider the following portfolios.*
As you can see, the portfolio split between the S&P 500 and the MSCI EAFE produced a higher return than did either index. And it also produced a higher Sharpe Ratio than either index, despite the MSCI EAFE having a lower Sharpe ratio than the S&P 500.
However, our analysis doesn't end here. Consider the following example: The performance of two giant global pharmaceutical companies like Merck and Roche is likely to be more highly correlated -- because their products are sold all around the globe -- than the performance of two small-cap domestic pharmacy chains that are only located in their home countries. In other words, the returns of international small companies are driven more by local, idiosyncratic factors. This makes them more effective diversifiers than international large-cap stocks.
We can see this more clearly when we substitute international small-cap stocks (represented by the Dimensional International Small-Cap Index) for the large-cap stocks of the MSCI EAFE. Over the same period as used for the table above, the return of a portfolio with 50/50 split between the two indexes was 13.2 percent with a standard deviation of 20.8 percent. The portfolio is also more efficient than the others, with a Sharpe ratio of 0.467.
Further, the correlations data shows that international small-cap stocks are even better diversifiers than international large-cap stocks. For the period 1970-2010, while the correlation of the MSCI EAFE to the S&P 500 was 0.66, the correlation of the Dimensional International Small Cap Index to the S&P 500 was just 0.48. Not only do international small companies have higher expected returns than do international large companies, but their lower correlation demonstrates that they make more effective diversifiers as well.
The evidence demonstrates that including international large-cap companies in your portfolio has historically improved returns and delivered those higher returns in a more efficient manner. The evidence also shows that even greater benefits have been obtained by including international small-cap stocks.
* This table has been updated to show the correct annualized standard deviation of a portfolio that is 100 percent S&P 500 Index. Previously, the table showed the average annual standard deviation of 11.56 percent.
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