The need for international diversification

The need for international diversification

            International diversification refers to an attempt by portfolio managers to reduce risks by investing in financial instruments in more than one country. By diversifying across countries whose economic cycles are not correlated perfectly, fund managers can effectively reduce the risk exposure of their investors by varying the levels of their returns (Hodrick, & Zhang, 2014). According to Capar and  Kotabe (2003), among the many benefits of globalization of investments is the improvement in the efficiency of global capital allocation and improved ability to diversify investment portfolios.   The flow of capital between nations moves marginal rates of return in various locations close together and in the process offering domestic and international investors better returns.

Fund managers must, therefore, use an appropriate mix of international portfolios to design an efficient frontier portfolio. Markowitz’s efficient frontier is one of the essential methodologies of creating a diversified portfolio.  An ideal collection is one that conforms to the cutting-edge hypothesis.   This hypothesis allows speculators to continuously attempt to reduce risks while also making efforts to optimize returns.  The hypothesis, therefore, denotes that speculators at any given time, are reasonable and their subsequent actions would be aimed at settling on alternatives that are meant to optimize their returns for risk or danger of moderate amount.  The work of Harry Markowitz in 1952 theorized the concept of an ideal portfolio.  He accomplished that objective by hypothesizing the efficient frontier hypothesis and demonstrating how fund managers like Sandra Meyer and her team can come up with portfolios with a wide range of risk-return profiles (Simaan et al., 2018).  Fund managers must, therefore, choose the most appropriate risk-return profile based on the customer’s financial preferences.   The convergence and divergence of the various international stocks indices  returns can be seen in the graph below;

Fig 1. Fluctuations in the international stock indices returns

The robust performance of the US stock market at any given time does not undermine the case for international diversification because the volatility of any given region may change at any given time.  In other words, a bullish stock market can quickly turn bearish within minutes or days, thereby sending negative sentiments and signals throughout the entire US stock market. , it would be prudent to use an international diversification strategy to capitalize on the varying levels of risk exposures provided by the regional and international economies.

One of the most critical financial metrics of portfolio management is the Sharpe Ratio. Before delving deep into the implications of higher Sharpe ratios, a brief background of its significance is essential. According to Hodrick and Zhang (2014), modern portfolio theory is based on the proposition that investors are generally attracted to high returns and have an inherent dislike for the volatility of returns due to losses associated with it.   Therefore, the more variable the portfolio return for any given mean, then the higher the probability of loss and the bigger the losses if any occurs.  Sharpe ratio is a vital risk statistic of the risk-return tradeoff that characterizes a portfolio of securities.  It measures the average excess return of any given portfolio relative to the volatility of the return.

The reason why US investors should invest abroad if the US Stock market has a higher Sharpe ratio is that investing abroad improves the Sharpe ratio. The US investor’s Sharpe ratio improves whenever a small amount of foreign assets is included in their U.S portfolio. That occurs when the Sharpe ratio of the new asset is higher than the Sharpe ratio of the domestic or U.S collection when multiplied by the correlation between the foreign return and the US stock market (Hodrick, & Zhang, 2014). In essence, a lower correlation of any given foreign asset with the US market, the better the condition.  The implication is that low correlation across countries is what forms the fundamental argument for engaging in international diversification.  The calculated Sharpe ratios for the counties for the 1991-2001 period are shown below;

Table 1. Sharpe ratios for the 1991-2001 period

Correlation and its importance

            If the performance of two countries’ stock markets is highly correlated, it merely means that they all move in lockstep with each other, thereby making it difficult to diversify a portfolio in the concerned markets.  The volatilities and returns in such countries would also most match each other, thus reducing the level of diversification.  Modern portfolio theory uses correlation as a measure of the amount of diversification. The level of diversification is, therefore, useful for determining the most efficient frontier.  The correlations for the provided nations in the case study were calculated and found as follows;

Table 2: Correlation of the market indices for various countries

From the analysis, the US/Canada diversification would have a 0.7710 correlation.  That is quite high and undesirable. For US investors, the best states for diversification would be China, with a correlation of 0.0508 and India (0.0912).  The implication is that the correlation between the US and Chinese sectors is low. Meaning that the sectors or economies react differently to risks.  It may also imply that the same risks and returns do not drive the US and Chinese sectors.

            The estimated correlation has been noted to change over time. The estimated correlations change over time due to the varying level of risk and returns within specific regions.  In other words, the changing volatility index of various counties is what makes the estimated correlations to change over time (LOretan & English, 2000).  Market risk and sentiments change over time in reaction to specific market conditions; these changes in volatility are what make the estimated correlations to change over time.           

            Changes in exchange rate present a significant risk to the returns that Boss may enjoy.  Exchange rates are essential in the determination of the relative volatility of two economies. A high level of exchange rate volatility could significantly erode or increase returns that Bosse might enjoy depending on the direction of the change in volatility.

            The decision to put actual weight on EAFE would depend on the level of correlation between the S&P 500 and EAFE.  A low level of correlation is desirable for proper diversification to be achieved.

Analysis reveals a 77% correlation between EAFE and S&P 500. S&P 500 has a better correlation of just 10.6% with EM.

Desai et al. (2013) noted that some US investors are not internationally diversified due to their risk avoidance behavior.  That behavior emanates from reports of underperformance of other developed nation equities vis-à-vis U.S.  Additionally, news such as Brexit crises spells trouble to some investors.

Discussion and Conclusion

            Risk management is one of the most critical aspects of fund and portfolio management. International diversification is one of the most popular strategies of risk management that is employed by fund managers. Several scholars have reported a definite link between international diversification and portfolio performance (Lu & Beamish, 2004; Thomas, 2006; Chang & Wang, 2007).   There are several theories on the most appropriate strategies for building the most profitable and low-risk volatility portfolios. One of the most popular ones is Markowitz’s portfolio theory. In this case, the analysis indicated how international diversification could improve the risk profile by providing sufficient information on stock correlation and Sharpe ratio. These two metrics can then be used by fund managers to come up with an appropriate mix of an investment portfolio when building an efficient frontier.