Steven Schoenfeld is a Managing Director of Barclays Global Investors, and the chief investment strategist and team leader of its International Equity Management Group, which manages over $65 billion in developed international and emerging market index investments. He is the editor of Active Index Investing to be published in late 2002.
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An international/non-domestic equity allocation always provides diversification to an investor's portfolio.
International investing has come under fire in the US for two main reasons: tighter correlations between global markets, and the huge U.S. bull market of the late 1990s. Both these reasons are clear examples of short term performance and ' rear-view mirror investing'. Looking at long term performance, in the 336 months between 1973 and 2000, international equities ( proxied by MSCI EAFE) and US equities (S&P 500) moved in opposite directions 115 times or 34% of the time. However, in the 132 months in which the S&P 500 went down, EAFE posted a positive return in 55 of those months - 42% of the time.
So, even though the common argument is that international doesn't provide diversification in the times when it's most needed (when the domestic market is falling), in reality, international markets have posted positive returns more often in those periods than over all periods. Higher correlations in recent times were driven by the increased dominance of tech stocks in all global markets, and as their weight has dropped the correlations are dropping as well.
In fact, the truly risky portfolio is the one that does not include some foreign equities. Even in the 90s, investing 20% of a portfolio in international equities (EAFE), would have reduced volatility from 13.4% to 12.9%. More impressively, over the last three years (ending Dec 2000) when the argument for international not being a good diversifier has been most popular, an equity portfolio with a 30% allocation to EAFE would have been less volatile than a portfolio fully invested in the S&P 500 - 16.4% vs. 17.7%.
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Don't define international/foreign too narrowly - you'll often miss the best action.
Many investors define 'international' in a constrained way, for example: US investors just investing in EAFE/developed markets, thus missing out on opportunities in Canada and emerging markets. Similarly, many European investors focus too much on their home region, and outside the continent .
A broad, international portfolio that includes emerging markets and Canada in the proportion of their market capitalization (ACWI ex-US), has delivered better risk and return characteristics than one invested solely in the developed international markets (EAFE). The more complete portfolio would have returned 7.2% with an annualized standard deviation of 16.5% as opposed to a return of 6.9% with an annualized standard deviation of 16.9% for EAFE (Jan 1988 - Dec 2000).
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Even as globalization accelerates, national factors/country allocation still matters - a lot!
As the world has become more integrated, the influence of sectors has increased. However, countries are still the key drivers of return differentials. This is because, even in an area as closely linked as the EMU, there are significant differences in government economic and fiscal policies.
More importantly, the level of human capital differs substantially across countries. This translates into either different industry compositions or, at the very least, different levels of value added processes in the same industry. For equity markets, this means divergent market returns and therefore far from perfect correlation. Some sectors have always been global in nature (oil, technology etc.) while others are clearly driven by local factors (retail etc.).
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All emerging markets are not created equal - and those with a potential to 'graduate' are the long-term winners.
It is important to distinguish between 'top- tier ' emerging markets which are on the path toward convergence with developed market standards (and often into developed-market trading blocs such as the EU and NAFTA). Portugal and Greece have both successfully graduated , and those investors who were there early benefited.
Future 'top-tier' emerging markets would include Mexico, Brazil, Israel, South Africa, Poland, Taiwan and Korea. It is countries such as these which have the potential for the most rapid economic growth and market returns.
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Domestic multinationals - or even global multinationals - are no substitute for broad international equity exposure.
As attractive as the concept might sound - generally something like "buy global winners to capture the benefit of international markets without the risk" - the reality is that one does not get the diversification advantage of foreign stocks with multinationals.
Domestic MNCs tend to have a beta close to 1.0 with their home market, and large-cap global MNCs are usually the most highly correlated both with each other and with large developed markets. To truly reduce risk and potentially enhance return, one needs stocks with a high degree of local content, and adequate exposure to at least the top 15-18 emerging markets.
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Concerns about the currency exposure of international equity investment tend to be overblown - for allocations of less than 15%, the appropriate attitude should be "don't worry, be happy"
The currency risk you take with foreign stocks is not always a bad thing. In fact, if international stocks are less than 15% of your total equity portfolio, the currency exposure actually adds diversification with minimal risk. That doesn't mean it will always help absolute returns, but it is not a cause for major concern.
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Always/only using traditional active management isn't optimal for international equity exposure.
Despite the conventional wisdom that the inefficiency of international markets requires active management, it is important to remember that costs are typically higher outside the home country. And the more the manager trades, the higher these costs can be.
Traditional active funds have higher costs and fees due to higher turnover , a disadvantage of approximately 100 bps, resulting in a performance hurdle of approximately 150 bps relative to the index. Exploiting inefficiency is easier imagined than done: while many active managers beat benchmarks like EAFE in the 90s by systematically underweighting Japan, this is a much harder exercise today.
Furthermore, the move by MSCI and other benchmark providers to float-adjustment and broader coverage will provide fewer outperformance opportunities in non-index stocks. The most important benefit of international diversification comes from simply getting the exposure - international/global index funds let investors own the market and thus efficiently capture the primary benefit of foreign equities.
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Global index investment is anything but passive.
Investment styles are often broadly divided into active and passive. The term passive is used to indicate the lack of a mandate to produce an excess return over the benchmark. However, in practice, a well run index fund is anything but passive. The first decision is the choice of benchmarks - this depends on the client's preferences for factors such as comprehensiveness, investability and degree of acceptance. The next step is to decide how to weight the component countries if the choice is a regional/global benchmark. The default is of course market capitalization weights. But, several other weighting methodologies exist - equal weights, minimum variance weights, GDP weights etc. For any set of weights except market capitalization weights, the rebalancing schedule also needs to be decided. That could again be based on either a calendar cycle or on a target percentage deviation from the initial weights.
Replicating the performance of the index within countries is not just a matter of buying the initial set of assets and letting them run. There is a litany of events that need to be addressed on a regular basis. These include reinvesting dividends , ensuring the optimal decision is made during all types corporate actions and managing the level of cash efficiently. A key area that differentiates a good index manager is how they respond to large index changes. Each index change requires a specific trading strategy that takes into account the magnitude of changes, the period between announcement and implementation, the amount to be traded and the presence of other parties on the same and opposite sides of the trade.
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If you invest internationally 'a-la-carte' make sure you use the appropriate vehicles.
ADRs can be an effective tool to buy foreign stocks, but can give lumpy exposure. Single country closed-end funds tend to have erratic discounts and very high expenses. Regional mutual funds (and closed-end funds) provide uncertain asset allocation within the region - it's hard to know exactly what exposure you're putting in your portfolio.
International/global Exchange-Traded Funds (both country/regional and global sectors) are appropriate and efficient for both short-term and long-term investors - and for both passive and active approaches . You know what's in the fund, you can get in and out efficiently and at close to NAV, and you can use their modular structure to create virtually any variety of customized portfolios.
