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International Investing

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Gary Karz, CFA (email)
Host of InvestorHome
Founder, Proficient Investment Management, LLC



     The primary reasons to invest internationally are high returns and diversification. While foreign stocks are typically more volatile than U.S. stocks, adding international exposure to a portfolio will normally reduce the risk of the portfolio without lowering returns. A portfolio of 80% US stocks and 20% international stocks will likely have similar yields with less risk than a portfolio of 100% US stocks. There is however a historical relationship that investors should be aware of. When the U.S. market goes down sharply, the correlation with foreign markets goes up. In other words, the benefit of diversification is reduced during sharp downturns in the U.S. For example in the crash of 1987, most foreign markets also had large drops. A common wall street adage is "when the U.S. stock market sneezes, the rest of the world catches a cold." But over longer periods of time (months and years) the correlations between markets are low.

     The negatives of investing internationally include higher expenses (transactions, management and custody fees), taxes issues, and operational issues (disclosure, accounting, etc.). Additionally, there are added political and currency risks. Investors should also keep in mind that returns from international investing can be heavily influenced by currency movements which can also result in higher volatility. When analyzing past performance, currency effects should be differentiated from local returns. When the dollar is appreciating, returns from foreign investing will be reduced and vice versa.

     In an award winning article titled Where Are the Gains from International Diversification? (January-February 1996 issue of the Financial Analysts Journal) Rex Sinquefield questioned the arguments that diversified international portfolios and EAFE in particular (1) substantially diversify a U.S. portfolio and (2) have higher expected returns than the U.S. equity market. Based on empirical evidence (from Fama, French, Sharpe and others) from 1970-94, Sinquefield argues that two risk factors (value and size) explain differences in returns in both the U.S. and foreign market. Further he argues that international value and international small stocks diversify U.S. portfolios more than EAFE. Sinquefield therefore concludes that "a sensible reason to diversify internationally is to 'load up' on value stocks and small stocks without concentrating in one geographic region." Why Invest Globally? is another opinion on the matter - by Jarrod W. Wilcox of PanAgora Asset Management.

     International Investing Options include

     The issue of openness matching refers to the percentage of foreign goods in an investor's market basket. That is, an individual who purchases 10% of their goods from foreign sources should consider investing in foreign assets accordingly to "match" the future consumption needs. However, this perspective does not take into account the return and diversification benefits of international investing.

     Investing directly in foreign securities creates a number of dynamics resulting from playing by the rules of the foreign countries. The range of reconciliation between foreign accounting and United States accounting goes from 0 to 100%. Foreign companies that list their stock on US exchanges provide full reconciliation to US standards while most foreign listed companies provide no reconciliation. (See also about financial statements.) The bottom line is that you can not make general conclusions about valuation levels in different countries without a thorough understanding of accounting and other differences between the countries.

     Robert D. Arnott and Tan K. Pham argued (in an article titled Tactical Currency Allocation in the Financial Analysts Journal, September-October 1993) that currency markets are not completely efficient because "Two of the largest communities of currency traders have no profit motive. Central banks trade to dampen volatility. Corporations seek to hedge currency exposure in their book of business. . . . we conclude that currency markets are not efficient. Their inefficiencies follow a historically reliable patter, which is consistent with what we know about global capital flows. Any inefficiency is, of course, an arbitrage opportunity; if enough capital is invested in a fashion that exploits the inefficiency, it can and should disappear. However, the currency markets are large and liquid, and have a major class of investors (the central banks) that does not care about profits. Accordingly, we see no reason for these inefficiencies to dissipate quickly."

     Studies have shown that an allocation of as high as 60% for international investments can provide improving risk/return benefits, but advisors commonly recommend allocations in the 10% to 30% range. A Greenwich Associates survey found that by year-end 1995 the average allocation to international securities for 1,592 large funds had risen from 1991's 4.4 percent to 10.4%. Ronald Liesching, director of research at currency-overlay manager Pareto estimated that funds with $1 billion or more in assets had international allocations averaging 18% (Source: Institutional Investor, "Hedging on hedges," June 96).

     According to Institutional Investor ("Far from home" by Miriam Bensman, April 1996), International equities had $29 billion in net cash flows from US Pension funds in 1995 of which $13 billion was placed with index managers. $5 billion went into fixed income. The total of $34 Billion was down from 1994's $40 billion and 1993's 42 billion. CalPERS had roughly 20% of its $100 Billion fund allocated to international investments. According to Philip Halpern, CIO Washington State Investment Board, "Trading costs for international investing can be as much as 150 basis points a year, so your behind from the get-go. . . . If you include investment management fees of 50 to 100 basis points, you start 200 to 250 basis points behind the game with an active manager." The article added, "Emerging markets, of course, are exactly the sort of inefficient markets that appear likely to reward skilled stock picking. But big funds fear they'll swamp stocks by taking concentrated bets; in addition, the median manager in this category has underperformed. The reason: Transaction costs exceed even those for developed international markets, and money managers are inexperienced."

Emerging Markets

     Emerging markets are typically defined as countries with low per capita GNP. While developing countries make up over 80% of the worlds population, they have historically made up less than 10% of the world stock market capitalization. The benefits of investing in emerging markets include high returns and greater diversification, while the risks are greater than investing in developed countries.

     While emerging markets have become much easier to purchase, thanks to mutual funds and ETFs (like Vanguard's VWO), concerns include include political uncertainty, lack of company information, lack of liquidity, trading and custodial difficulties, confidentiality and insider trading problems, as well as even higher transactions costs compared with developed countries. However, emerging markets as a group have much lower volatility than the individual markets because of low correlations between the markets. Industries play a larger role in explaining return of developing markets, while country differences play a larger role in the emerging markets.

     Vanguard has some well written articles on the topic of international stock market investing and emerging markets. In Are investors truly embracing international diversification? they note "emerging markets captured most of the cash moving into international equities in the most recent time spans: 66% over 1 year and 97% over 3 years" versus 30% over 5 years and 25% over 10 years. Of the $149 billion that flowed into emerging market stocks over the past decade, 83% arrived during the last 5 years. They note the risk is that if U.S. stocks do outperform for a time, many investors will reallocate back to the U.S. market after the fact, launching a new round of buying high and selling low.

     In Considerations for International Equity they note that since 1985, emerging markets have produced an average annual return of 12.2% with a volatility of 24%, versus average annual returns for developed markets over the same period of 9.2% with volatility of 17.3%.

     In Investing in emerging markets: Evaluating the allure of rapid economic growth, "they caution long-term investors against making asset allocation decisions solely on the basis of expected economic growth. Our analysis shows that the average cross-country correlation between longrun GDP growth and long-run stock returns has been effectively zero." They conclude that "over the past ten years, emerging markets investors were rewarded for the risk they bore not because of high economic growth per se, but rather because of comparatively low equity valuations in the early 2000s coupled with consistently higher than expected economic growth throughout the period. As of year-end 2009, market valuations and consensus GDP growth expectations for emerging markets are higher than they were ten years ago."

     Bill Bernstein summarized the fallacy that fast growing countries and companies should translate into stronger returns in The Investor's Manifesto where he noted that "China's economy has been growing at a blistering 9 percent real rate per year for more than two decades. Yet between 1993 and 2008 investors actually lost 3.3 percent per year in Chinese stocks, even with dividends reinvested. Similarly he notes that the Asian tigers--Korea, Singapore, Malaysia, Indonesia, Taiwan, and Thailand-- since 1988 have all had lower returns than the low-growth United States.

     John Bogle (who coincidentally has a new book out titled Don't Count on It!) was interviewed by Morningstar and suggests that investors should consider currency and sovereign risks and limit international exposure to 20% of your portfolio, maybe half in emerging markets and half in developed. That's interesting in that most traditional asset allocations have much lower international allocations to emerging versus developed markets. But that could be consistent with some predictions from analysts like the following.

     The importance of emerging markets is noted in a Financial Planning article noting that Morgan Stanley Trumpets Bull Market (11/10/10) and the prediction is that 93% of the global middle class will come from emerging markets by 2030 (up from 56% now) per World Bank data. This P&I article titled Institutions seen tripling emerging markets equity weighting (9/9/10) speculates that pension funds and other institutional investors based in developed markets could raise their emerging markets equity weighting to 18% in the next 20 years from the current 6%, according to research from Goldman Sachs, driven by an expectation of emerging markets eventually having the largest share of the global equity market. According to EM Equity in Two Decades: A Changing Landscape, the rise in emerging markets would amount to a 9.3% compound annual growth rate through 2030, compared to an expectation of a 4% growth for developed markets equity (over the past 20 years, emerging markets equity has grown at a 15.9% compound annual growth rate and developed markets at 6.5%).

     According to Boston-based Pioneering Management Corp., over the 50 years through 1995, emerging market equities showed average annual returns of 16.5% compared with 12.4% for the S&P 500 and 11.8% for the EAFE index (Source: Business Week 9/9/96). The Institute of International Finance estimated $33.1 billion flowed into emerging market stocks in 1996.

     As pointed out in Scary Investments...That Work from SmartMoney (10/14/2010) 59 percent of advisers plan to boost their clients’ exposure to emerging-market stocks (according to investment-management firm Russell Investments).

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