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International Exposure
Long-Term Benefits of Diversifying Abroad Still Exist
 by Ernie Ankrim
Chief Investment Strategist
Russell Investments
In spite of recent suggestions to the contrary, it still makes sense for most moderately risk tolerant investors to hold up to 40% of their long-term investments in US and international stocks or mutual funds.
Some advisors in the United States are advising their clients to cut international portfolio exposure to as little as 5 percent. Their reason: International markets are moving in line with domestic equities and therefore provide little diversification. Spreading your investments among bonds or a variety of domestic market sectors is a more effective way of reducing risk, they argue.
Most recently, Merrill Lynch advised its wealthy US private clients to limit the foreign stocks in their portfolios to about 5 percent, down from the 35 percent recommended just last year. J.P. Morgan Chase also advised clients to reduce their international exposure. If such recommendations were based on short-term market forecasts, we would recognize them as tactical portfolio shifts. But the main purpose behind these recommendations has been that international exposure offers "reduced diversification benefits".
True, domestic and foreign markets — particularly those in Europe and Asia — have tended to move in the same direction in recent months. But concentrating on trends over a few months, or even a year, can produce strategies with disappointing long-term results. While recommendations to cut back on investing in international stocks have been dominated by concerns in recent trends over the correlation between domestic and international returns, this still rings of a short-term bet on the Canadian or US markets. For investors with a long- term perspective, making portfolio moves based on short-term movements can lead to the classic case of running from the coldest asset class to chase after the hottest.
So what does this mean to the Canadian investor? The broader view reveals that the highest three-year quarterly correlation between Canadian and international equity returns over the past 20 years occurred in the three-year period ending December 1999. For that same period the TSE 300 Index returned 14.2%, while the MSCI EAFE Index returned 18.3%. For this period when the correlation of quarterly returns was at its peak, the difference between Canadian and international returns was more the 4% annually.
Canadian investors were wooed by the prospect of achieving higher returns if they invested overseas and as a result cash began to flow out of the Canadian market. For the year ending December 31, 2000 approximately 3 1/2 times more cash flowed into international funds then to Canadian funds. Over that same one-year period the TSE 300 Index returned 7.4% while the MSCI EAFE Index returned -11.0%. It is clear that investors who chased after international returns were not rewarded for their market bet. Moreover, extensive research by Russell and others has continuously shown that investors who chase last year's winners are, on average, worse off in the coming year. Investors who fell in love with Internet stocks in 1999 can attest to this.
Looking ahead over, say, five years, it is almost certain that returns on Canadian, US and international stocks will be different, regardless of what happens in the short-term. If you're an investor who knows for sure whether domestic or international stocks will dominate the financial landscape over the next 20 years, weight your portfolio heavily in that direction. But if you're like most humble investors, don't count out international diversification just yet. It might prove to be the best move you can make. You'll give up the chance to be exactly right, but you'll certainly avoid being exactly wrong.
Past performance is not a guarantee of future performance.
This is a publication of Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited. Frank Russell Company, a Washington, USA, corporation, operates through subsidiaries worldwide.
All indexes mentioned are unmanaged and cannot be invested in directly.
Russell 1000® Index is an index of 1,000 securities issues representative of the US large capitalization securities market.
The MSCI Europe, Australasia, Far East Index (EAFE, pronounced EEE-fah) measures the performance of the leading stocks in 20 developed countries outside of North America.
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