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  • Home>Research & Insights>Investment Insights>The Case for International Diversification

    The Case for International Diversification

    It pays to diversify a stock portfolio globally, even though most large companies are global. 

    Alex Bryan, 09/27/2017

    A version of this article previously appeared in the May issue of the Morningstar ETFInvestor.

    How strong is the case for investing in stocks outside the United States? Vanguard founder Jack Bogle has argued that U.S. investors don’t need to venture into foreign markets because 1) most large U.S. stocks generate a large portion of their revenue outside the U.S., 2) foreign stocks have greater currency and--in many cases--greater macroeconomic risk, and 3) returns across different markets should be similar over the long term. With similar expected returns and greater risk, non-U.S. stocks aren’t appealing--in Bogle’s view (which Vanguard doesn't share). But investors who limit themselves to the U.S. market miss nearly half of the world’s available equity market capitalization. A closer look reveals that while the benefits of international diversification will likely be modest for U.S. investors, non-U.S. stocks should have a place in most investors’ portfolios.

    Business has become increasingly global in the past few decades. Where a company is incorporated and traded is not necessarily indicative of the economic exposure it provides. Most large-cap firms are global organizations, which means that investors don’t necessarily need to venture out of their home market to get international exposure and that foreign-listed stocks may offer less diversification than their places of incorporation would suggest.

    It also means that confining a portfolio to a single market artificially limits the opportunity set, placing many strong companies out of reach. For example, when Inbev (the European maker of Stella Artois) bought Anheuser Busch, it took the company out of U.S. indexes--even though the combined company continues to have significant exposure to the U.S. market. If Inbev takes market share away from Molson Coors TAP (a U.S. brewer), U.S. investors will lose out. The market does not compensate this type of diversifiable risk. Other examples include Toyota Motor TM/General Motors GM and Nestle NSRGY/Kraft Heinz KHC. In addition to mitigating this type of risk, international diversification is sensible because it reduces exposure to country- and region-specific risks (such as interest-rate and political risk).

    From January 1970 through March 2017, foreign stocks lagged their U.S. counterparts, with greater volatility. But this divergence in performance illustrates the benefits of investing globally. Sometimes U.S. stocks will lead foreign stocks, other times they will lag, but they should offer similar returns over the long run. As long as these returns are less than perfectly correlated, foreign stocks can help diversify risk. Exhibits 1 and 2 show the relative performance of U.S. stocks against foreign stocks, denominated in both local currencies and U.S. dollars.

    Currency risk has made foreign stocks more volatile than their U.S. counterparts, as shown in Exhibit 2. Yet the global, market-cap-weighted stock portfolio exhibited volatility comparable with the MSCI USA Index, owing to the less-than-perfect correlation between U.S. and foreign stocks, which averaged 0.65 during the sample period. That said, correlations between U.S. and foreign stocks spiked in the late 1990s and early 2000s and have remained elevated since, as shown in Exhibit 3. If this trend continues (and it probably will, in light of greater global integration), foreign stocks will likely offer smaller diversification benefits going forward.

    Alex Bryan is an ETF analyst with Morningstar.