International Diversification: Is It Still Worthwhile?

With all the recent turmoil in Europe, Index Funds Advisors, Inc. has received questions from clients regarding whether there is still an expected benefit from international diversification in equities. In 2011, international and emerging markets indexes lagged behind their domestic counterparts, as shown below:

Total Return in 2011*

*Source: DFAUS.com and ifaindexes.com

However, for the prior ten calendar years (2001 to 2010), international outperformed the U.S. in seven years and emerging markets outperformed in nine years. During this period, IFA was sometimes asked why the international/emerging markets equity allocation was not higher than the current 35%.

To quantify the benefit of international diversification, the number most often referred to is the correlation coefficient which measures the strength of the relationship between two variables (e.g., domestic and foreign stock returns). Specifically, a correlation of 1 means that the pair of random variables move in perfect unison together, and a correlation of -1 means that the pair of random variables move perfectly in the opposite direction from one another. A correlation of zero means that the two variables are completely independent of each other. For the purpose of portfolio construction, lower correlations are more desirable than higher correlations because they result in a lower volatility for the portfolio, as shown by Harry Markowitz¹ in the work for which he was awarded the Nobel Prize in 1990.

Beginning with the financial crisis of 2008, correlations increased above their normative historical levels, as shown below:

Monthly Correlations with US Equities*

*Source: DFA Returns Version 2.2 and ifaindexes.com

If the higher recent correlations are part of a “new normal,” then there would be less of a benefit to international diversification. If, however, it is just an anomaly, then international diversification is still prudent. The returns of the last few months suggest the latter as a possibility, yet our behavioral tendency of extrapolation leads us to presume that foreign equities will continue to underperform and our emotionally-driven reaction is to sell out of foreign in favor of domestic equities. Regarding the high correlations of the 3-year time period above, Markowitz in an article on ifa.com explains it as the expected behavior of asset classes during a financial crisis and its aftermath.²

IFA reminds investors that the essence of a good diversifier is its ability to move in the opposite direction as the asset that they wish to diversify. This means accepting the fact that there will be time periods where they would have been better off without the diversifier. The problem, however, is that there is no way to reliably predict when these time periods will occur, so the best course of action is to buy, hold, and rebalance a sensibly constructed global portfolio of index funds for the long term.

1. Markowitz, H.M. (March 1952). "Portfolio Selection.” The Journal of Finance 7 (1): 77–91
2. Markowitz, H.M., Hebner, M.T., Brunson, M. (July 2009) “Does Portfolio Theory Work During Financial Crises?”