The Benefits of International Diversification Are Gone

Preview of the 2011 Global Investment Conference.

Share:
  • Facebook
  • Twitter
  • Print
  • Email
  • Comment

story_images_domino-tilesAs a speaker at this spring’s Global Investment Conference in Banff (April 5 – 7), Peter Christoffersen, finance professor at the University of Toronto’s Rotman School of Management, will be presenting his research on how conventional diversification is no longer the free lunch it once was. In advance of the conference, we asked him to answer questions about how the diversification game has changed and why emerging markets offer better risk protection. To find out more about Peter’s presentation and the Global Investment Conference, click here.

Q: How has the benefit of international diversification changed over the years?

A: What our research is showing is that the benefits of international diversification are very much disappearing if you consider a portfolio of equities from developed markets only. If you think about just buying the country equity indices in a bunch of developed markets, you will see that the correlations among those countries have gone up and up and up.

What is quite amazing about this – and when I say that, most people’s reaction is: “well of course, it’s the financial crisis” – is that is very much not what’s going on. Our sample for developed markets goes back to the early 1970s and the increasing trend in correlations has been going on for at least 20 years.

So it’s not just a recent bump that comes from the whole world going crazy at the same time in 2008 and 2009 –  it is something else going on. It’s the forces of globalization, very broadly defined, like capital controls disappearing and so on –  that’s a process that has been going on since at least the early 1980s and it looks like that has really impacted these correlations, and impacted them in a bad way for investors. That’s something investors really need to know.

Q: How would investors use that knowledge?

A: From a risk management perspective, the worst thing that you can do is overestimate the benefits of diversification. You want to be cautious and you want to be conservative and you don’t want to assume that you have diversification benefits when really you don’t.

The other effect that we’re seeing is that when volatility is high in the markets – that’s really when you want to have the diversification benefits to be there, that’s when you really need them – that’s when they’re not there. Correlations tend to be higher when volatility is high so that’s very bad for investors also. So there’s several reasons to be very cautious in terms of saying “I’m diversifying across a bunch of countries, so my risk is low.” No it’s not. Not if the countries you have are all developed economies.

Q: What happens when you put emerging markets into the equation?

A: We find that it does change the picture quite a bit. We still see a trend over time that the correlations between emerging markets are increasing over time, but the level is much lower. So that means that the benefit of diversification in emerging markets is much higher than from developed markets.

Q: There’s two sides to this, correlations between emerging markets, and correlations between emerging markets as a whole and developed markets.

A: We look at the overall correlations between the markets all together, so let’s say we have something like 20 developed markets and 13 or 14 emerging markets, then we look at the overall correlations between those. So let’s say you put together a portfolio of all those countries, developed and emerging, and what you find is the increase in correlations is there. So the diversification benefits are there from a worldwide portfolio, but they are slowly disappearing as well over time.

What you would need is to put a lot of emerging markets in your portfolio. We’re essentially putting together equal-weighted portfolios. Institutional and private investors do  nothing like that. They may have 5% or 10% in emerging markets, which is much less than an equal-weighted share.

So the benefits are there, to some extent, when you include all countries together, but you need to have a pretty significant exposure to emerging markets to get that. We all have this sort of knee-jerk reaction to think of emerging markets as being very risky, but in this respect they actually do give you some diversification. And we look at diversification benefits not just from correlation but also we look at it from extreme movements in the markets.

So what’s the extent to which two countries move down together in a large move? The probability of that is very high in developed markets, which is very bad news. If one developed market moves down, another one is likely to do so. You don’t find the same thing for emerging markets at all. There, large moves seem to be more isolated, country by country, than is the case for developed markets.

To learn more about the Global Investment Conference, please visit the events section of the website. If you are interested in attending the event, please email Garth Thomas to be considered, as limited space available.

You might also like...
Add a Comment

Have your say on this topic! Comments that are thought to be disrespectful or offensive may be removed by our Canadian Investment Review admins. Thanks!

Transcontinental Media G.P.