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International Diversification

 

The main reasons to invest internationally are to capture higher expected returns and to diversify portfolios across a broader array of asset classes. This can lower the overall volatility of a portfolio and increase the likelihood of benefiting from the return premiums associated with different risk factors.


Allocations to international small cap and value stocks, which historically have had higher average returns than their broad equity market, are not highly correlated with the broad US equity market and diversify US portfolios better than international equities that are value and size neutral. Adding allocations to emerging market small cap and value stocks provides further portfolio benefits via an even broader array of asset classes.


Portfolio Experiments


The portfolio experiments presented in tables 1 & 2 that follow are based on an article by Rex Sinquefield (Financial Analysts Journal, Jan- Feb 1996). The portfolio weights are completely arbitrary and not the result of an optimization. Different weights might have yielded completely different results. There are three core messages:


First, a large allocation to a market like portfolio of international equities produces only a small improvement in the risk return profile of a portfolio.


Second, worldwide diversification allows the stock-bond ratio of a portfolio to be increased without raising the overall risk of the portfolio because returns between the broad US and International markets are not perfectly correlated.


Third, assuming investors are willing to bear the corresponding risks, they would be better served if their allocation to international equities were tilted toward small cap and value stocks.


The base portfolio, Portfolio 1, is a 60/40 portfolio that allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond index. Between 1975 and 2010 Portfolio 1 has an annual average return of 11.7% with a standard deviation of 11.9% (see table 1). Portfolio 2 maintains the same 60/40 ratio as Portfolio 1, but it splits the equity allocation between the S&P 500 Index (40%) and the MSCI World ex US Index (20%). Adding a market-like allocation to international equities in the portfolio reduces the average return by 2 basis points and produces a reduction of 0.4% in the standard deviation of the portfolio.


Table 1

Portfolio Combinations with Broad Market Allocations

Asset Class (1975-2010)

P1

P2

P3

P4

S& P 500

60

40

46

41

MSCI World ex US

0

20

21

26

Long Term Bonds

40

40

33

33

Total

100%

100%

100%

100%

Avg Annual Return (%)

11.7

11.5

12.0

11.9

Avg Annual Std Dev (%)

11.9

11.4

11.9

11.9


How big of an increase can be made in the stock-bond ratio of a portfolio with a market-like allocation to international equities without increasing the volatility of the portfolio? The allocation to equities in this sample can be increased by slightly less than 7% before the volatility of the portfolio climbs higher than that of the original portfolio. And as Portfolio 3 and 4 shows it does not matter whether most of that increased allocation goes to US, or international equities. Those portfolios have approximately the same annual standard deviation as portfolio 1 and an increase in the annual average returns of 0.2% and 0.3% respectively. One of the core messages from the Sinquefield article is that a market like allocation to international equities produces only a small diversification benefit. The second core message from the article is that international small cap and international value stocks diversify US portfolios better than market–like allocations to international equities.


Table 2 shows the risk and return benefits of tilting a portfolio of international equities to small cap & value stocks.Portfolios 5 and 6 are 60/40 portfolios similar to portfolios 1 and 2 in table 1.


Table 2

Portfolio Combinations with Size and Value Tilts

1970-2010

 

 

 

 

 

 

 

Asset Class

P5

P6

P7

P8

P9

P10

P11

P12

S& P 500

60

40

40

40

40

30

30

30

US Large Value

-

-

-

-

-

5

3

3

US Small Value

-

-

-

-

-

-

3

3

US Small Cap

-

-

-

-

-

5

5

5

MSCI World ex US

-

20

-

-

-

-

-

-

Int’l Value

-

-

20

-

10

10

10

12

Int’l Small Cap

-

-

-

20

10

10

10

10

Barclays Cap US Gov/Credit

40

40

40

40

40

40

40

38

Total

100%

100%

100%

100%

100%

100%

100%

100%

Avg Annual Return

11.4

11.3

12.4

12.6

12.5

12.8

13.0

13.2

Avg Annual Std Dev

11.4

11.0

11.1

11.2

11.1

11.3

11.3

11.7


From 1970-2010, Portfolio 5, the base portfolio, a 60/40 portfolio that allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond index, would have had an annual average return of 11.4% with an annual standard deviation of 11.4%.


Portfolio 6 maintains the same 60/40 equity debt ratio, but it allocated 40% to the S&P 500 Index and 20% to the MSCI World ex US index. Its average annual return from 1970 to 2010 would have been 1 basis point lower than the return on portfolio 5, although its risk would have been 0.4% lower than portfolio 5.


Portfolio 7, which shifts the 20% allocated to international large stocks from the MSCI World ex USA to international large value stocks, starts to show the benefits to investors of tilting an allocation to international equities toward small cap or value stocks. Portfolio 7 has a slightly higher volatility than Portfolio 6, but its annual average return is over 1.10% higher.


Portfolio 8, which allocated 20% to international small cap stocks, does even better.  Its average annual return would have been 12.6% with an annual standard deviation of 11.2%.


Portfolio 9, which splits the 20% international equity allocation evenly between small and large cap value stocks, would have had an average annual return of 12.5% with a standard deviation of 11.1%.


Portfolio 10 increases its exposure to small and value stocks both in the US and internationally. Its average return from 1975 to 2010 would have been over 1.40% higher than the base portfolio (12.8% vs. 11.4%) with a volatility that is 0.1% less than the volatility of the base portfolio.


Portfolio 11 is similar to portfolio 1, with the only difference being that Portfolio 11 splits the allocation to US value stocks even between large cap and small cap. Its average annual return would have been 13.0% with an annual standard deviation of 11.3%.


Finally, Portfolio 12 has a slightly higher standard deviation than portfolio 5, but its average annual return is 1.8% higher than the return of portfolio 5 (13.2% versus 11.4%). That improvement in the risk/return profile of the portfolio is achieved by increasing the equity allocation by just 2% and tilting the portfolio toward small and value stocks, both in the US and internationally.


Summary


The portfolio experiments suggests that if international small cap and value stocks are not highly correlated with the broad US market or with US Small cap and value stocks, investing in these international and emerging market asset classes can improve the risk/return profile of a portfolio (Markowitz, 1959). Investors who want to increase the expected return of their portfolios and are willing to accept the corresponding risks, should tilt their portfolios toward small cap and value stocks accordingly.


Data Sources and Description


For the US market, the S&P 500 was used. For US Small, the CRSP 6-10 Index was used. US value and growth data provided by Fama/French. Int’l large growth and value data provided by Fama/French.  US Treasury bond and Bill data provided by DFA. Stocks, Bonds, Bills and Inflation Yearbook, Ibbotson Associates. The Barclays Government/Corporate Bond Index 1-30+ years was used where indicated for fixed income data. (Cardiff Park, 2010)