8 
8 THE ETF REVOLUTION HAS OPENED UP NUMEROUS OPPORTUNITIES for investors, especially in the area of global investing. Investors today have access to a wide range of vehicles for investing in foreign equities, bonds, and currencies. On the equity side, an investor can invest in ETFs that provide easy access to dozens of country, sector, and global themes. The bigger question is, to what degree do you want to take advantage of these opportunities?
All the evidence points to the fact that investors in the United States and elsewhere do not take full advantage of international diversification opportunities. This “home bias” flies in the face of the evidence from academic finance that supports the idea of globally diversified portfolios. In prior decades, there were real barriers to international investing, not the least of which was the high cost of investing overseas. Now the easy access to ETFs makes this argument largely moot.
For years, the idea of foreign diversification for U.S. investors was a secondary concern. And for decades, the United States was by far and away the largest equity market in the world, with upward of 90% of the world’s market capitalization. The United States is still the largest equity market in the world, but its position has been greatly diminished. Recently the United States was estimated to have 40% of the global market capitalization.1 By this measure, Japan is still the second largest stock market in the world.
It was the bull market, turned bubble, in Japan in the 1980s that really opened people’s eyes to the potential of overseas investing. Another factor that helped along the way was the growing realization that the U.S. dollar was falling in value against other major currencies. One way investors could take advantage of this trend was by owning foreign securities.
Very few U.S. investors today have 60% of their equity portfolios overseas. The same is true for non-U.S. investors, only more so. Think about the case of Canada, which by last count had approximately 5% of world market capitalization. Very few Canadians have likely mirrored world market capitalization by having 95% of their holdings overseas. This psychological barrier is the home bias at work.
It is said that familiarity breeds contempt. However, in the world of finance, as Gur Huberman puts it, “familiarity breeds investment.”2 Huberman showed that investors were far more likely to invest in their local regional Baby Bell company than in any of the six other Baby Bells, this despite the fact that there were no real barriers to diversification. Maybe we shouldn’t be all that surprised by these findings, because mere exposure has a powerful psychological effect.
Research shows that exposure to something that doesn’t harm us actually changes our brains, hence the “mere-exposure effect.” That’s why we are more comfortable around familiar things. Jason Zweig writes, “Being in the presence of familiar things (even when we are unaware of them) simply makes us feel better.”3 It is not a big stretch to see how this effect would affect our own investment decision making. Zweig notes that this is why we feel more comfortable buying stocks in companies with products we are familiar with and use. Another way in which this manifests itself is in the realm of company stock. Because we are familiar, and presumably comfortable, with the companies in which we work, we are particularly comfortable holding company stock. A concentrated position in any single security, let alone the company you work for, is a situation rife with risk.
We have already discussed the virtues of portfolio diversification. If home bias is a barrier to achieving that goal, then the thoughtful investor needs to take steps to overcome this bias. There are two ways in which we can approach this problem. The first is a bit more analytical. For investors reluctant to invest overseas, we need to put in proper context the size of our domestic market relative to the world. Seeing that even the largest market, the United States, is well below half of the world market cap can help prod investors to look more closely at international investments.
The other approach stems directly from the mere-exposure effect. Simply exposing ourselves to news and information about overseas markets can help overcome that bias. It need not be a rigid, formal process. Merely spending more time on international coverage can help familiarize ourselves with the broader world around us. This serves not only our portfolios but also our general knowledge.
We have so far not discussed international bonds. In part this has to do with home bias. When it comes to foreign equities, at least we come across household names. In the realm of sovereign bonds, this is not likely the case. In that regard, diversification into foreign bonds is a higher hurdle. However, given our goals of broad diversification, considering foreign bonds as an investment is well worth doing. Like international equities, there are an increasing number of vehicles that invest in foreign developed and emerging market bonds. Given the turmoil surrounding the state of U.S. domestic finances, a trend toward more diversified fixed-income portfolios is likely to continue.
Most investors will never take a full market cap–type weighing to overseas markets. Indeed, a formal portfolio construction process would likely not recommend this large a weight anyway. All investors need to do is consciously overcome the home bias and approach international diversification without undue bias. Every trend in place points to a more globalized economy and financial system. Portfolios need to reflect that reality.
On Friday, August 5, 2011, Standard & Poor’s downgraded the sovereign credit rating of the United States from AAA, where it had been since 1941, down to AA+. This has important implications for the U.S. economy and financial markets. The following Monday, the global equity markets were in free fall, with every major equity index ending down substantially on the day. On this day, it wasn’t surprising that the S&P 500 ended down more than 6%, but the MSCI EAFE index that tracks foreign developed markets was down even more.
You wouldn’t think that a downgrade of the credit rating of the United States would affect the rest of the world’s capital markets, but it did. We could spend pages trying to dissect the intricacies of what happens on a day like that, but it’s sufficient to know that this is how our interconnected global markets operate. In an increasingly globalized world, what happens in one country, especially one like the United States, can affect the rest of the world. This incident was yet another example of how in times of stress the global financial markets have a tendency to trade as one.
In an ideal world, that isn’t how international diversification is supposed to work. In an ideal world, the zigs of the U.S. market are supposed to be offset by the zags of the international markets. This global portfolio is supposed to provide a smoother ride for our portfolios. Unfortunately that isn’t how things work these days—and this is why the idea of international diversification has come under fire. The experience of the financial crisis and subsequent bear market made it abundantly clear that as financial stress increases, the correlation on risky assets has a tendency to approach 1.0. Markets all begin to trade in unison on the upside and on the downside.
For this reason, some commentators have suggested that U.S. investors can get all the international exposure they need simply by holding stock in companies that do a substantial part of their business overseas. On the surface, this argument is very appealing. Not having to diversify internationally tugs on our home bias. These same commentators likely recommend that investors diversify among large-and small-cap U.S. stocks. However, these two asset classes are far more correlated than the U.S. market is with any other foreign stock market. The point is that just because an asset class doesn’t provide ideal diversification does not mean we should write it off summarily.
No one in this day and age should be surprised that the correlation between markets increases in periods of stress like bear markets and economic recessions. For nearly two decades now, research has shown increased correlation in periods of market stress.4 The big insight is that the correlation structure among countries is not, and frankly never was, static. The naïve case for international diversification has always rested on the idea that these correlations would hold up in difficult market times.
If anything, the phenomenon of rising correlations has only gotten more acute over time. It is clear that the global economy has become more globalized. A quick glance at our own spending would likely show that a significant portion of our consumption comes in the form of products produced, in part, overseas. So when a major earthquake hits in Japan, the supply chains across the world feel the pain.
Globalization is not limited to the production of goods. The service sector is increasingly opening up to trade across borders. This is occurring because the technological infrastructure is in place to allow for seamless communications across borders. This free flow of information affects how news and trends diffuse across the globe as well. Globalization will never be complete, because national identity is still important; but it cannot be dismissed as a reason for increasingly correlated financial markets in the short term.
Just as in the real economy, the financial markets have also become more integrated. It didn’t used to be common practice to watch what was happening in overseas markets, but investors these days are paying increasing attention. Now that investors can easily trade these markets using ETFs, it is worth their time and effort to track them more closely. This sea change in attention affects how the markets work in practice. In periods of market stress, investors looking to reduce risk now can, with the push of a button, sell Japanese stocks just as easily as they can stocks in the S&P 500. Electronic trading in that sense has blurred the distinction between what is domestic and what is foreign.
Despite all this evidence that globalization is occurring in the real economy and financial markets, there is still a case to be made for investing globally. Despite the increase in correlations, a standard approach to building portfolios still puts a substantial weight on foreign assets. Chen, Goodwin, and Lin find that for a U.S.-only investor, any sort of international diversification makes sense in that it improves a portfolio’s risk-return profile.5 For investors already well diversified in large-cap developed and emerging market equities, there are but a few very limited additional diversification opportunities.
Despite the talk to the contrary, the benefits of global diversification are still real, albeit more limited in scope than they were. A more nuanced argument in favor of global diversification takes into account the fact that no country, including the United States, is free from a host of existential risks. Therefore, diversification is more than a simple portfolio tool; it is a concerted attempt to make our portfolios more real-world risk resistant.
Part of the confusion and controversy regarding international diversification really centers on the question of time frame. Investors want to believe that international diversification will work for them no matter what the markets are doing. When the U.S. market is up, we want our international investments to tag along for the ride. When the U.S. market is down, we would prefer that our international investments don’t go down. In short, we don’t want to be disappointed by our decision to diversify.
In a sense, disappointment is the essence of diversification. We have seen this at work with diversification among bonds and stocks. Bonds, by and large, are not going to provide outsized investment returns. However, in times of severe market stress, they can provide much needed portfolio ballast. Under normal market conditions, our bond investments are a nagging disappointment.
What investors need to avoid is faux diversification. Faux diversification occurs when new and novel asset classes turn out to have exposures that are roughly similar to those of already existing asset classes. The investment industry is always on the hunt for new investment products it can market as novel asset classes. This nomenclature tends to cement in investors’ minds the unique nature of the new fund or strategy. The fact is that there are few truly novel asset classes whose returns are not affected by the risk factors common to most risky assets.
Like other many other approaches to investing, diversification is harder than it looks. One reason why recognition of the home bias is such a powerful phenomenon is that it forces us to think about our own country in a less than flattering light. Nobody wants to think that the United States, or any home country, isn’t the best investment bet. That is in fact the very reason why international diversification is so important. We aren’t talking about the zigs and zags of the current global economy. Rather we are talking about the big, secular economic shifts that occur over decades.
The Standard and Poor’s downgrade of the sovereign credit rating of the United States, mentioned earlier, was a watershed event. The downgrade highlighted in a tangible sense just how far the United States had gone off track. As Fareed Zakaria writes: “Instead, we have demonstrated to ourselves, the world and global markets that our political system is broken and that we are incapable of conceiving and implementing sensible public policy.”6 This incident underscores how a country can lose its standing over time, or as Justin Fox writes, how the United States needs to come to terms with losing its status as the “world’s dominant economy and has to learn to get by instead as one of the world’s dominant economies.”7
None of the problems that led to the S&P downgrade happened over night. The relative decline of the United States economy is something that investors should have been keenly aware of. This is exactly the reason why investors should think about international diversification with the long term in mind. In a really interesting paper, Asness, Israelov, and Liew posit a unique way to think about just what international diversification is supposed to accomplish.8
Asness et al. come to three main conclusions. The first is that the short-term benefits of international diversification are largely absent. As noted in the prior section, the global financial markets have the frustrating tendency to decline in unison these days, largely eliminating the benefits of international diversification. This “co-skewness” is unlikely to disappear any time soon. Over the intermediate term, the uncertainty inherent in international diversification comes via valuation. As noted earlier in the book, valuation plays a large role in how equity markets perform relative to one another even after taking into account economic growth.
Second, the authors note that over the long run it is specific economic performance that drives equity market returns. If this is the case, then there is the potential for countries and their equity markets to diverge over time. The risk for investors is that they are concentrated in a country that has exhibited, or is going to exhibit, relatively poor economic performance over a long period of time. As an example, we mentioned earlier the case of Argentina and how it spent much of the twentieth century losing its relative economic status.
Last, they note how international diversification over the long run can serve to mitigate some of these big risks. Asness et al. write: “Diversification protects investors against the adverse effects of holding concentrated positions in countries with poor long-term economic performance. Let us not fail to appreciate the benefits of this protection.”9 In this framework, global diversification serves as a hedge against the existential risk of local economic stagnation.
The point of this is not to denigrate the United States or somehow imply that the future performance of the U.S. economy is going to be markedly worse than its historical performance or poor compared with economies around the world. It simply means that investors, here and abroad, need to contemplate the possibility of an extended run of bad luck. Protecting against adverse outcomes is the whole point of diversification. Fortunately for investors in the United States and other developed countries, there is a growing pool of countries and markets in which we can look for additional investment opportunities.
The term emerging markets is a bit of a misnomer these days because it covers a wide range of countries in both size (China and the Czech Republic) and level of development (Taiwan and Egypt). Emerging markets are best thought of as countries that still lag more developed countries in some important economic, political, or financial fashion. These markets are generally believed to be riskier than their more developed counterparts, hence the often bright lines drawn between the two camps. This distinction matters because of the importance of global benchmarks and the investments that flow from them.
There always seems to be some controversy about which markets should, and should not, be considered emerging markets. What is not in dispute is that emerging markets have been standout performers in the past decade. In the decade ended in 2010, emerging market equities and emerging market bonds were the two best-performing asset classes, racking up annual returns of 16% and 11%, respectively.10 These returns stand out in comparison to the roughly 2% annual returns that U.S. stocks earned over this period. This outperformance has pushed the weighting of emerging markets in the MSCI All-Country World index up from below 4% at the start of the past decade to nearly 14% today.11
While this performance was impressive, the economic advances in the emerging markets were even more impressive. The emerging markets, especially the much-hyped BRIC nations of Brazil, Russia, India, and China, experienced rapid economic growth, particularly in comparison with the developed world. When Europe and the United States were going through their own debt crises, the emerging market bonds began to look and trade more and more like a safe-haven asset class.12 This is a far cry from where the emerging market story began the decade.
The case for investing overseas was primarily built on the idea that foreign assets would provide diversification benefits. This idea was first applied to the developed markets and then naturally transitioned to the emerging markets. The challenge for investors is that along the way both economic and financial trends worked to reduce the benefit of global diversification. In a very real sense, the global economy became more integrated. The end of the cold war and decisions by the world’s most populous nations (China and India) to become much more open economically helped push this process along. As trade and capital flowed across borders, the world’s economies became more sensitive to what was going on in the rest of the world.
At the same time, the increasing sophistication of investors and the shift of trading onto electronic platforms brought globalization to the financial markets as well. International diversification used to be a much more costly and arduous process. In short, you had to want it. As markets became increasingly open and electronic, the practice of international diversification became simpler and cheaper. As we noted when talking about ETFs, international diversification today is just a mouse click away.
John Authers, in his book The Fearful Rise of Markets, talks about the “diversification paradox.”13 The paradox is that as investors increasingly bet on the benefits of noncorrelated assets, it made it more likely that the benefits would prove illusory. When the financial crisis hit, it did not matter to investors that one asset read Chinese equities and the other read U.S. equities. All that mattered was that they were both risky assets—and risk was something to avoid.
In this sense, emerging market diversification failed. That should not be all that surprising given our earlier discussion. What is surprising is that anyone believed that these markets would somehow decouple in the midst of a serious bear market. Nor has this experience stopped investors from looking for the next opportunity in the emerging markets. For some investors, their goal is a new combination of markets that can rival the past performance of the BRIC nations.
Other investors are looking to even smaller and less developed markets for opportunities. You can best think of these frontier markets, for example, Argentina, Romania, and Vietnam, as the minor leagues of the emerging markets. These frontier markets trade with a lower volatility and lower correlations to the U.S. market than more advanced emerging markets.14 Despite the higher cost of investing in frontier markets, these markets represent a unique diversification opportunity.15 Investors hope that these countries get a boost from the transition into full-fledged emerging markets. In short, getting called up from the minor into the major leagues.
Even though the idea of investing in emerging markets took a hit in the financial crisis, the search for opportunities overseas did not slow for long. One emerging asset class that did not take a major hit in the financial crisis was emerging market bonds. One could argue that the status of emerging market bonds has been enhanced by the financial crisis and the subsequent debt crises involving Europe and the United States. Emerging market bonds now represent to many investors a viable safe haven. This is due to the relatively strong fiscal position many of these issuers now find themselves in. Unfortunately for investors looking for additional yield, emerging market bond prices now reflect this positive news.
A significant reason why emerging market bond and equity markets performed so well in the past decade is that they saw an upward revaluation. Markets that were once shunned had become mainstream investments. Some will argue that these markets still have a marked growth advantage over the developed markets, which is likely true. Investors should not forget that the stock market is not the economy and vice versa. The same holds true for the emerging markets. The emerging markets will likely continue to grow as a part of the global markets, but that does not necessarily mean they will outperform.
For better or worse, the emerging markets have been caught up in the ETF wave as well. Fund sponsors have brought out all kinds of single-country equity ETFs and sector ETFs covering the larger emerging equity markets. On the bond side, there are now local currency emerging market bond ETFs and funds that cover specific geographic regions. This sort of granularity for traders is great. It gives them more opportunities to make specific bets. BRIC hype aside, research shows that it is difficult to forecast those emerging markets that are going to outperform.16 For the vast majority of investors interested in gaining some exposure to the emerging markets, this level of granularity is unnecessary. It is hard enough picking what sectors will do well in the U.S. market, let alone trying to select winning sectors in Brazil or China.
That being said, investors are going to continue to optimize their exposure to the emerging markets. The opportunity is simply too large to ignore. If investors can no longer count on the easy benefits of diversification, then fund managers and investors will look for new ways to invest in the emerging markets. This might include approaches already used in developed markets, for example, low-volatility strategies. In any event, there is going to be no shortage of ways for investors in the future to invest in the emerging markets.
The coming decade for the emerging markets is not likely to be a repeat of the past decade. The biggest issue facing investors in the emerging markets is not the markets themselves but the high expectations for them. Despite the great strides many countries have made, real risks still exist in these markets. History tells us that the path to developed nation status comes with serious bumps along the way. Emerging markets are an important part of a globally diversified portfolio, but they no longer represent the easy diversification play they once did. Nor can, or should, investors count on their continued outperformance.
We have been discussing the nature and importance of global investing and have so far ignored a critical part of foreign investment returns: currencies. To gain access to any kind of overseas investment, stock, bond, or cash, it involves dealing in a foreign currency. From the outset, we should recognize that the foreign exchange (forex) markets are the largest financial markets in the world. By last count, some $4 trillion in currency changes hands every day, and that number seems only to be rising.17 The Bank of International Settlements estimates that retail traders account for 8–10%, or $125–$150 billion, of forex trading.18 No matter how you measure it, these are big numbers.
Before we go any further, we need to make a distinction between active currency trading and the passive exposure gained to currencies via an investment in overseas assets. Individual investors should recognize that currency trading is by all accounts a money-losing proposition for the vast majority of traders. In contrast, the diversification benefit of international investments comes in part from the exposure to foreign currencies.
There is no doubt that there is a great deal of activity on the retail forex front, but the question is whether the clients are generating any profits. On this question, the evidence is decidedly negative. Statistics compiled by the Commodities Futures Trading Commission, or CFTC, from the companies that provide retail forex services show that approximately 75% of customers lost money each quarter in the last year for which statistics were compiled.19
This should not be altogether surprising, because the deck is stacked against forex traders. First, traders are usually using a high amount of leverage (up to 50 times). Second, traders are dealing with firms that are acting as a principal and not an agent. In other words, they are trading against the house. Last, there are few limits placed on who can trade currencies, and so experience is no hurdle to opening and trading a forex account.
All these factors lead to very high customer attrition at the major forex firms. That means that a large fraction of their customers are dropping out of the game. As Joshua Brown writes: “The online currency trading shops are modern-day boiler rooms … I am not arguing that making money trading currencies is impossible, I am saying that most people who try are merely being taken advantage of.”20
The lure of forex trading is easy to understand. Trading in the most liquid, visible markets in the world seems on the face of it to be a manageable proposition. However, once you mix in a high level of leverage, it turns forex trading into a losing proposition for the vast majority of people who try it. Avoiding situations where the odds are stacked against you is an important aspect in trying to keep your portfolio on track.
Institutional investors are not immune to the lure of foreign currencies. Many large investors have embraced currencies as a separate asset class. There is some evidence that these professional managers have been able to generate some gains above and beyond some already established benchmarks.21 Even for institutional investors, forex profits are no sure thing. For example, there is some evidence that the profitability of trend-following strategies in well-established currencies seems to have eroded over time.22 This is not surprising, since all markets evolve over time, and those managers who are fishing in the forex waters need to constantly search for new methods to generate profits.
This constant search for forex profits is at best a sideshow for long-term investors. We don’t have to engage in hyperactive trading to benefit from currency exposure. We discussed earlier how international diversification should best be thought of as a long-term proposition. Gaining exposure to overseas markets implies a currency exposure as well. The whole point of this diversification is to offset the potential risk that your home market will turn out to be a negative outlier over the long term.
Another way to think about currency diversification is based on the idea of natural hedges. A natural hedge is an exposure to an asset class that also serves to hedge your ongoing consumption. We all recognize that a significant portion of the goods we buy comes from overseas. If the value of the dollar declines over time, which many believe to be the case, the cost of those imported goods will increase in dollar terms. Having an investment in foreign currency naturally helps offset this effect.
What investors can’t do is invest overseas, hedge out the currency risk, and expect to get true international diversification. Foreign bonds and equities have lower correlations with domestic asset classes in part due to the currency returns. The process of currency hedging offsets some of the return benefits of global assets. If the whole point of international diversification is to gain long-term exposure to overseas markets, then currency hedging seems an unnecessary step.
Thanks to the financial services industry, exposures to foreign currency returns need not come only through equities or longer-term fixed-income instruments. Individual investors now have access to every major currency and many minor currencies in the form of exchange-traded instruments. Individual investors can also access specialized bank deposit accounts that provide exposure to foreign currencies. Investors can think of this as diversifying their cash holdings.
For a long time, and even today, foreign investments have represented an opportunity for investors to try to create more efficient portfolios. That task has become more difficult over time as markets have converged. That being said, investors who ignore the increasingly global nature of the economy and financial system are likely to get left behind. In a certain sense, international investing was one of the first attempts at alternative investing. The search for uncorrelated returns continues to this day in a number of different ways.
Home bias prevents most investors from taking full advantage of the benefits of international diversification.
An increasingly global economy and financial markets have reduced, but not eliminated, the benefits of global diversification.
The greatest benefit of global diversification may come in the very long term in protecting investors from the existential risk of economic stagnation in their home market.
Emerging markets are an important part of a globally diversified portfolio, but they no longer represent the easy diversification play they once did. Nor can, or should, investors count on their continued outperformance.
Foreign currency exposure plays an important part of international diversification, but most individual investors should actively avoid forex trading.