Will International Diversification Increase Returns?

     In my last post I discussed the potential for international diversification to reduce volatility. As we saw, the data is inconclusive at best and over recent years international diversification has actually increased the worst kind of volatility. In this post we'll analyze the potential for international diversification to increase returns.

     It is worth noting that the UN recognizes 195 sovereign countries BlackRock has 267 non-US iShares ETFs, with the ability to invest specifically in 42 individual countries. If you want to index Poland or Argentina iShares will do it for you -- expense ratios are in the 50-60 basis points range. We can be fairly certain that in any given year the US will not provide better returns than every one of those 42 countries. So "diversifying" with the right country will always provide better returns. However, investors have no reliable way to pick the right country. For the purposes of this article, when I refer to international investing, unless stated otherwise, I am referring to investing in the total international stock market as whole. I believe this is reasonable because the entire international stock market is close to the same size as the US stock market.

     One question that an investor needs to ask when considering international investing is "What about the Efficient Market Hypothesis?" The Efficient Market Hypothesis (EMH) is the idea that because all investors have access to the same information, and because all investors desire to maximize their returns while minimizing risk, assets in the market are priced efficiently, i.e. everything that is known about them is already reflected in the price. Since this theory has decent logical and empirical support why not just invest in the entire world by market capitalization? There are a couple reasons why the EMH may not be the best guideline in this case.

     For one, although the United States does a pretty good job of protecting investors not all countries have the same strict laws about insider trading. The United States is the leader in insider trading laws, with virtually every country lagging behind, and even though most major stock markets now have insider trading laws, they are in most cases woefully under-enforced. Retail investors should think twice before investing in a market that doesn't protect retail investors.

     Second, international investing is subject to unique risks. Obviously there is some exchange rate risk, but over the long term that should be mostly a wash unless the US Dollar continues to grow stronger without the other world currencies ever catching up. More importantly, there is the risk that the other countries in the world are not necessarily our friends. China in particular, has a growing economy and growing influence, and they are the ideological enemies of virtually everything that us freedom and McDonalds loving Americans hold dear. Investing in their stock market gives them valuable liquidity, and aids them, however incrementally, on their path to world domination.

     The one significant advantage that the international stock market has is that it is cheaper. Vanguard Total US Stock Market ETF (VTI) has a dividend yield of 2.4% while Vanguard's Total International Stock Market ETF (VXUS) has a dividend yield of 3.49%. If we accept that stock market returns are a combination of dividend yield, earnings growth, and changes in valuation and assume that long term changes in valuation will be nominal, then it follows that the US stock Market will have to have an earnings growth rate 1% higher than the rest of the world in order to provide equal returns. Over the long term that could be difficult, but for shorter time periods, say 30 years or less, it shouldn't be a problem.

     Investors who are wary of investing in Chinese, Russian, or Middle Eastern countries can choose to invest in only developed international markets. However, the main benefit of international investing, lower valuations, is smaller in developed markets; Vanguard's Developed Markets ETF (VEA) has a dividend yield of 3.0%. Investors who want to select specific countries can do so with Black Rock Ishares, but the cost, 50-60 bps puts a damper on any potential benefit.

     So should you invest in international stocks? Expert opinion on the matter ranges from Burton Malkiel who recommended 50/50 US/International in his book "A Random Walk Down Wall Street," to the late Jack Bogle who always argued that international diversification was unnecessary and unhelpful. Vanguard currently recommends that 40% of stocks be invested internationally. My opinion is that older investors shouldn't invest internationally unless they really want to. I do not believe that the slight potential for marginally higher long term returns justifies the probability of higher short term volatility for investors with a short time horizon. Investors with a long horizon should consider investing 10-40% of their stocks internationally and should be cautious about investing in countries that are ideological enemies of the United States.


Disclosure: Joe Bailey is a Registered Investment Advisor in the State of Nebraska. He owns Vanguard mutual funds personally and recommends them to clients. All investments involve risk including the possible loss of the money invested, and past results are a remarkably poor indicator of future performance.
   

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