Diversification has long been espoused as an important virtue of a successful equity allocation. But to what degree should a U.S. investor’s portfolio be diversified between U.S. stocks and international stocks? We have reviewed this issue to seek to identify an optimal asset allocation.
International equity provides a portfolio exposure to market influences that expand beyond the U.S. market. These factors bring about differing returns in foreign countries and therefore reduced correlation with the U.S. International currencies add another layer of diversification as they do not move in line with equity prices and therefore help to reduce the correlation between U.S. and foreign stocks. As a result of the reduced correlation, historically, the volatility of a portfolio that holds international stocks as well as U.S. stocks is lower than a U.S. only portfolio. While over the past 40 years U.S stocks have offered a slightly higher return than international stocks, when a portfolio is created with a combination of the two it results in a portfolio with less volatility, but similar returns. Thus, a globally diversified portfolio has offered better risk adjusted returns than a U.S. only portfolio.
More recently we have seen the diversification benefits of including an international equity allocation decrease. Correlations between the U.S. and international stock markets have moved more closely together since 2000 and including an international equity allocation has not provided any benefits over the past three years. However, correlations have changed throughout the past 40 years. There have been other historical periods where having a very low allocation to foreign stock has been the optimal portfolio allocation followed by periods where having a higher level of international stock would be preferable. While correlations between the U.S. stock market and international markets will likely be higher going forward than they were in the 1970s through 1990s, we believe that they will return to a reduced level as they have done in the past. Thus, they will continue to be an important part of a diversified investment portfolio.
With the benefits of investing globally established, the next step is to determine to what degree an investor should incorporate international equity in their portfolio. A starting point is to invest based on a market neutral approach. Under this scenario an investor would hold the global market weight of equities in their portfolio. This scenario would result in a portfolio that has slightly less than 50% allocated to U.S. stock and slightly more than 50% allocated to international stock.
While the resulting expected portfolio volatility would be lower than that of a 100% U.S. equity portfolio, it would have the equivalent volatility of only a 15% allocation to international equity. Thus, it can be fine tuned. By reviewing the historical volatility of international equity it shows that an investor would receive the full benefit of international diversification by holding roughly 40% of their equity portfolio in foreign stock.
However, correlations have differed over time and as a result the ideal combination of U.S. and foreign stock has varied. Reviewing international diversification over 10 year time frames, an investor would have realized the majority of the diversification benefit of international equity investing by maintaining between a 30% to 40% allocation to foreign stocks.
Another factor to consider is that inefficiencies exist when investing outside of the U.S. The average expense ratio according to Morningstar in 2011 for international equity index funds was 0.30%, whereas it was 0.19% for U.S. stock index funds. We use index funds here as they provide the most efficient allocation to each investment space and provide an apple to apples comparison. In addition, transaction and investment costs typically remain higher internationally than in the U.S. These issues reduce the benefit of a maintaining a higher level international allocation.
While we seek to maintain investment portfolios that are broadly diversified we also want to diversify efficiently and limit costs. Based on the above findings, a fully diversified portfolio would maintain a 40% allocation to international equities, but given the increased costs of foreign stock, likely higher future correlation, and similar levels of diversification that can be derived with a lower allocation we feel that a 35% allocation can deliver the exposure in a more efficient way. Although this is our general recommendation, individual investor circumstances can lead to different allocations being the right fit.
Index Performance April YTD Trailing 1 Yr
US Stock (Russell 3000) -0.66% 12.13% 3.40%
Foreign Stock (FTSE AW ex US) -1.52% 9.84% -12.64%
Total US Bond Mkt. (BarCap Aggregate) 1.11% 1.41% 7.54%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) 0.45% 0.34% 2.78%
Municipal Bonds (BarCap 1-10yr Muni) 0.92% 1.46% 7.08%
Cash (ML 3Month T-Bill) 0.00% 0.01% 0.05%