Does International Diversification Reduce Risk?

In a general sense, adding international funds to an investment portfolio is a tactic that is more often considered in the realm of “risk management strategy,” or the minimization of one’s exposure to domestic market swings, than a tactic to seek opportunity. Warren Buffett bluntly opined that “wide diversification is only required when investors do not understand what they are doing”, and the perfect definition can be found in Merriam Webster’s dictionary.

diversification: to balance (as an investment portfolio) defensively by dividing funds among securities of different industries or of different classes.

But before we jump into the “diversification doesn’t work” bandwagon, the key word in Mr. Buffett’s statement is “wide.” Although the term is subjective, I interpret his words as stating that one does not know how to invest when one points out that the more diversified assets one holds, the better protected one is. However, that logic often accompanies the investment advice behind the international diversification tactic being presented to investors, and being a defensive tactic by definition, the end result will be less than satisfying.

Certainly, there are opportunities in the global marketplace, and I like having capital available to try to capture profits, irrespective of an asset’s nationality. But the approach is one of seeking positive performance, and not a tactical hedge against broad domestic market fluctuations.

As a risk management tactic — and that is the meaning of diversification — the results leave a lot to be desired as far as global markets are concerned. Certainly, there are periods of divergence, and the proper advice will be able to anticipate movements and position one’s investments in the correct geographic location. But from a macro perspective, minimizing risk with international holdings only because they are “different,” simply does not deliver the advertised results, especially in extreme conditions. The chart that follows, which I included in a previous post about Europe, illustrates the performance of major global markets over the last three years.

click to enlarge

It’s apparent that every major market followed the S&P 500 into the abyss and then recovered — although one can state that the S&P 500 followed the other markets. That’s fair and I don’t want to split hairs. But the core point is that global markets reacted to macro economic conditions as a group, offering no consolation from a risk management perspective. The chart includes, in addition to the SPDR S&P 500 (SPY), ETFs for the following countries:

• iShares MSCI Germany Index Fund (EWG)
• iShares MSCI Switzerland Index Fund (EWL)
• iShares MSCI Europe UK Index Fund (EWU)
• iShares MSCI France Index Fund (EWQ)
• iShares MSCI Japan Index Fund (EWJ)
• iShares FTSE/Xinhua China 25 Index Fund (FXI).

But let’s get a broader view through a 5-year chart with the same ETFs listed above.

We see that China, Switzerland, and Germany outperformed the US market, while France, the UK, and Japan lagged. But where diversification is viewed as a risk management tool, the period around late 2008 and early 2009 shows a convergence, where all markets delivered close to the same broad results without discrimination. One can still argue that some markets lost less than others, and that is a fair point, and China stayed above the group. However, China joined the crowd, and dropped 50% from its 2007 heyday and, as a side note, the Chinese market’s much touted independence in view of macro global issues is non-existent.

Thus, international diversification for the sake of diversification may sound good, and may be fitting depending on the individual and the overall strategy, but the blank statement about risk management leaves much to be desired. The next chart shows the ETFs mentioned between October 2007 and December 2009.

Despite losses, Switzerland and Japan outperformed the S&P 500, and as investors and market players headed for the exits, safety and immunity to risk was virtually nowhere to be found. The purported diversification to minimize the impact on investments from a domestic “shock to the system” simply failed to deliver. However, and at the risk of sounding contradictory, diversification is beneficial and should be used within the context of timing and an understanding of economic factors, sentiment and perception, and global capital flows — not as a prescription implying that it is a portfolio's preventive medicine.

My diversification depends on the time period in question and I have very simple rules. The short-term upper limit is 12 stocks at any given time, with 6 stocks being the average. At times, foreign companies and international ETFs are part of the mix, while holding 100% cash was never a cause for concern. Current long-term strategy encompasses a field of six ETFs, and have never found the need to hedge with international holdings.

• SPDR S&P500 (SPY)
• PowerShares Nasdaq 100 (QQQ)
• SPDR KBW Bank (KBE)
• iShares Barclays 20+ Year Treasury Bond Fund (TLT)
• iShares Barclays 10-20 Year Treasury Bond Fund (TLH)
• iShares S&P GSCI Commodity Indexed Trust (GSG)

Capital allocation percentages vary according to market conditions and as of today, long-term positions are SPY-25%, QQQ-30%, and GSG-15%, with the difference in cash. And to clarify, my long-term approach is dynamic in nature; I use the term to differentiate from the so called "trading." While I may hold an investment for weeks, months, even years, as long as the market is favorable, I can change my mind at any time on any asset and reposition accordingly.

Around here, portfolio rebalancing is evaluated daily, not quarterly or every year, because markets don't quite get the calendar concept. And sometimes it only takes a few minutes to get a glimpse, and is not an agonizing process that contributes to the ever present threat of white hair -- or lack thereof -- taking over the real estate on my scalp.

Investment portfolio management is like gardening. Every day one admires the beauty, and if a plant appears to be under stress and becomes aesthetically disruptive, corrective action is taken without remorse.

Disclosure: I am long SPY, QQQQ, GSG.