The international diversification myth

By DAVID MOON, Moon Capital Management
March 27, 2005

MarketView seems to have touched a nerve by attacking overdiversification last month. (When offending readers, always blame some nebulous entity; never accept criticism in first person.) Columnists thrive on controversy, of course. So this column will expound further on the practical pitfalls of diversifying the kinds of assets you hold in your portfolio ' or at least doing so in the way preached by academicians and consultants.

The debate has been going on since the 1960s, when William Sharpe developed the Capital Asset Pricing Model. The model suggested that overall portfolio volatility could be reduced and returns increased by adopting a number of techniques, including expanding the universe of potential investments as widely as possible. One of the practical applications of this model was the widespread acceptance of the inclusion of foreign stocks in what were previously U.S. domestic-only stock portfolios. Since U.S. markets tended to zig while Japanese and European markets zagged, investors could reduce overall portfolio volatility by including stocks from these uncorrelated markets. ('Uncorrelated' means that two things have a statistical tendency to move in opposite directions.)

Over the long sweep of history this is certainly true, but the closer one gets to the present, the more correlated are the returns of the world's well-developed stock markets. The magnitudes of the returns vary across different countries' stock markets in a given year, but the direction of the change is more and more likely to be the same. The indexed returns of European stocks, Japanese stocks and the S&P 500 all increased in 2003 and 2004; in 2001 and 2002 they all declined. So much for non-correlated returns. (In the five years before that, the European and U.S. markets were also very highly correlated. The returns of the Japanese and U.S. markets were much less related, however.)

If you owned a European stock mutual fund in the last two years, these numbers may not make sense. The S&P 500 increased 10 percent last year, but your European stock fund probably increased twice that amount. In 2003, your European stock fund increased as much as 40 percent, compared to 20-something percent for most U.S. domestic stock funds. Does this suggest it is pretty foolish to ignore the international investing mantra?

No. You need to understand the underlying cause of the return of those funds. A significant portion of the returns of the 2003 and 2004 European stock funds was the decline in the value of the dollar. As the dollar declined in value against the euro, the value of the European stock funds increased for U.S. dollar investors. Otherwise, the return on the underlying European stocks in the portfolio was similar to the returns enjoyed by investors in U.S. funds. The benefits that international fund investors enjoyed were real. But their excess returns were solely a function of having bet on the U.S. dollar falling in value versus the euro. They shorted the U.S. dollar, and most of them not only didn't realize it, but probably didn't even understand it.

There are plenty of smart people investing in yen and euros, betting on a continued decline in the value of the dollar. But do most individual investors have a basis for shorting the dollar in their portfolios ' or is it simply a blind gamble, masquerading as diversification?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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