International Developed Country Stocks
Most of what was said above about small-cap stocks goes equally well—except more so—for international equities. The sector is a vast and inefficient one, hence manager skill and hard work can pay off handsomely. On the other hand, trading costs (and custody costs9) can be very high, bleeding away much of the advantage of international investing. Fortunately, as free market economic systems gradually spread throughout the world, the most bizarre and inefficient local market practices are fading away, to be replaced by trading institutions and mechanisms that look more like those in the United States and Europe. This is, however, a slow process, as older, inefficient players continue to exercise enough political clout to slow their own march toward oblivion.
There are many criticisms of international diversification. Some investors believe that international diversification is unnecessary, pointing to the very high correlations between the U.S. markets and international developed country markets that have persisted in recent years. Other investors concede the long-term benefits of international diversification, but point out that during very negative periods in the U.S. markets the international markets are also highly likely to be weak, rendering international diversification useless just when you need it most. Finally, some investors, even those who recognize the benefits of international diversification, simply distrust foreign markets (and foreign governments) and advocate gaining international exposure mainly through American Depository Receipts (ADRs).10 Let's examine these criticisms one by one.
International Diversification Is Unnecessary
It is certainly true that, from time to time, the correlations between U.S. equity markets and foreign equity markets increase. But to argue from this that international diversification is unnecessary is to drive by looking in the rearview mirror. Correlations among equity markets change slowly over time, but they are not monodirectional. During some market periods—especially those that are powerfully directional (up or down)—correlations will increase and we will conclude that international diversification provides no benefits. But no sooner will we eliminate our international exposure than—voilà!—correlations will move the other way and we will have lost the benefits.
It can, to be sure, be maddening to own international stocks during periods when they are both underperforming U.S. stocks and providing little diversification (as was the case during much of the 1990s). But because it is impossible to time correlation changes and investment return leadership, the only way to gain the long-term benefits of international diversification is to own international equities as a permanent core position in our portfolios. Thus, in constructing those portfolios we should establish a range for international exposure and remain near (but not below) the bottom of that range when correlations are high. As correlations decrease, our exposure to international stocks will typically rise of its own accord and it will now be our job to keep that exposure near (but not above) the top of the range.
Just When You Need It, Diversification Doesn't Work
This is, alas, all too true, at least if we think of our need for diversification as a short-term requirement. When the U.S. equity markets collapse, we can be pretty certain the international markets will also collapse. But if we wish to succeed as investors, we simply have to accept the fact that we cannot design portfolios that are both bulletproof and wealth creating. If we try to do so, we will end up failing as investors, mainly by consistently buying into markets at the top and selling out of them at the bottom. Bad markets—bad markets globally—are simply a part of the investment experience, just as bad periods are a part of any good marriage. The only way to make our portfolios bulletproof is to put all our money in U.S. Treasury bills and become slightly poorer every day.
It's understandable that clients become annoyed when diversification doesn't seem to be working. During global market crises, correlations do in fact go to one.
An important point to communicate to your clients is that diversification isn't designed to work at all times and under all conditions. It's not a short-term fix for volatile markets. The point of diversification—including, especially, international diversification—is to reduce the long-term price volatility of our investment portfolios. The reason for reducing portfolio volatility over the long term is that, the more volatile our returns, the lower our terminal wealth will be. (See the discussion of variance drain in Chapter 4.)
Thus, it is precisely when our clients don't seem to need it—when the price volatility of our client portfolios is being modestly suppressed by our international diversification—that diversification is doing its job. Yes, it would be nice if collapsing U.S. markets were always offset by rising international markets (or vice versa), but it doesn't happen that way. More important, it isn't necessary for it to happen that way for diversification to work its wealth-creating magic for our clients.
It's Easier and Safer to Gain International Exposure by Investing in ADRs
It's easier and safer, to be sure, but it's also mainly a waste of time. ADRs are issued mainly by gigantic multinational foreign corporations whose prospects are affected in the main by exactly the same factors that affect the prospects of gigantic multinational domestic corporations. Buying ADRs of BP isn't going to gain us any more diversification than buying ExxonMobil. There is nothing wrong with buying ADRs if we think the issuer is a good investment bet, but there is no point in buying them to obtain international diversification.
The Bottom Line
The best way to gain international diversification for most family investors is to look for international equity managers who are truly exposing their portfolios to regional, national, and even local factors. Some of these managers will be focused on smaller-capitalization companies whose prospects are inherently more likely to be dominated by nonglobal factors, while others will be buying larger-capitalization companies focused heavily on local and regional foreign markets. Owning these kinds of companies will, over the long term, tend to provide both diversification against a U.S. stock portfolio and also slightly higher returns—one of the few “free lunches” in the investment world.
As with U.S. managers, some international managers will tend to have a growth bias and some will have a value bias. If our portfolios are large enough, we may wish to gain exposure to both types of managers. However, international managers can also be classified as top-down or bottom-up in their approach, and this taxonomy is likely to prove more useful to us in diversifying our international exposure.
A top-down manager tends to observe conditions in global regions and countries and to decide which of those locations are likely to offer the most attractive investment prospects. Only then does the manager begin to look for individual companies in those regions. A bottom-up manager tends to look for the best companies regardless of where they may be domesticated, and then only secondarily will the manager make sure it is diversified regionally and by country. While the long-term results of these two types of managers will be similar, over intermediate periods of time, top-down and bottom-up managers will exhibit quite different return patterns, justifying diversification between those two approaches when possible.