Portfolio Diversification May Reduce Volatility and Enhance Investment Returns
Exposure to these Sectors Could Enhance Risk-Adjusted Return During the Recovery
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
The bull market that began in 2009 ended in 2020 when both the Dow Jones Industrial Average and S&P 500 posted greater than 20% declines from their highs. After years of economic prosperity and rising stock prices in the United States, the sell-off in stocks has been swift as investors brace for the possibility of a deep recession. Year-to-date through March 16, the SPDR S&P 500 ETF is down 25.5%, while the iShares MSCI EAFE ETF, a product capturing the large and mid-cap performance of developed markets outside the U.S. and Canada, is down 31.7%. The iShares MSCI USA ETF, a product capturing large and mid-cap performance of the U.S. market, is down 25.3%. While domestic equities have fared better than those abroad, should investors consider diversifying investments globally to better position portfolios for an eventual post-Coronavirus recovery?
Arguments in Favor
Foreign markets may offer better valuations. As of March 16, 2020, the yield on the iShares MSCI EAFE ETF is 3.48% compared with 1.90% and 1.43% for the SPDR S&P 500 ETF and iShares MSCI USA ETF, respectively. With the S&P 500’s recent outperformance, some believe international equities may offer superior value and appreciation potential. According to Yardeni Research, the EAFE and USA forward P/E multiples were 13.5x and 18.0x, respectively, as of March 11, 2020. Increasing exposure to international equities could provide greater upside when global markets stabilize and recover.
Lower volatility. While every country has its own set of risks, portfolio diversity among various asset classes and international versus domestic equities may reduce overall volatility. According to Vanguard, while most investors prefer to maintain significantly larger allocations to their home country, exposure to international equities helps to reduce portfolio volatility.
Greater risk-adjusted returns. Diversifying investments globally may enhance risk adjusted returns since investments are not tied to a singular business cycle. For example, if the U.S. economy is slowing, other countries’ economies may be expanding. According to an article by Ford Donohue, CFA, while international stock allocations up to 20% of a portfolio may enhance returns without increasing volatility, any increased international allocation is a trade-off between risk and return.
Lack of transparency. While the United States has a well-established legal and regulatory framework applicable to capital markets and corporate governance and disclosures, other countries may not provide the same level of assurance for investors. Additionally, with a heightened focus on ESG, U.S. companies may appear to be more focused on investor concerns. According to an article in the Financial Times, while Chinese companies have made progress in addressing environmental issues, corporate governance is still a sticking point.
Global markets are increasingly correlated. Due to globalization, diversification benefits may be decreasing as economies are increasingly linked and changes in the business cycle in one country can have a global effect. During periods of crisis when global markets experience greater volatility, the correlation between international and domestic investments may increase.
Domestic multinationals offer ample exposure. Many investors seek to gain exposure to international markets by investing in domestic companies that do business abroad. While this does provide exposure to international markets, investors limit return potential by not investing in leading global companies that may be headquartered outside their home country, or may benefit from greater diversification by investing in international companies that are more segregated and less global in scope.
Following the March 2020 declines in the market, now might be a good time for investors to review their portfolios and think ahead. Enhancing portfolio diversity to include exposure to various asset classes, industries and markets, may position portfolios to deliver better risk-adjusted returns over the long-term. International equities could offer portfolio diversification benefits and enhanced return potential, especially for those countries at a weaker economic starting point. However, because most investors lack the time to assess political and country risks outside the United States, investing in a mutual fund or exchange traded product that offers exposure to international equities may be desirable. A mutual fund that invests internationally have better resources than the average investors to assess investment risk and return potential. Whether individual stocks or a managed product, now might be the time to think about adding international exposure to reap the benefits of diversification during the journey ahead.
Understanding and Managing Political Risk, The Balance, John Christy, October 28, 2019.
Time to Put Some Money into Overseas Stocks, Forbes, Larry Light, January 25, 2020.
Global Index Briefing: MSCI Forward P/Es, Yardeni Research, Dr. Ed Yardeni and Joe Abbott, March 11, 2020.
Foreign Stocks Are Looking Cheap. 5 Ways to Take Advantage, Barron’s, Darren Fonda, October 22, 2019.
Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation, Vanguard Research, Brian J. Scott, CFA, Kimberly A. Stockton and Scott J. Donaldson, CFA, February 2019.
5 Myths of International Investing, Fidelity International Update, June 2019.
Chinese Governance Raises Red Flags, Financial Times, Siobhan Riding and Jennifer Thompson, June 1, 2019.
International Equities: Diversification and Its Discontents, Enterprising Investor, CFA Institute, Ford Donohue, CFA, November 19, 2019.