International Diversification: Does it still hold water?

The Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should hold a well-diversified portfolio to reduce risk. Empirically there has been a low correlation between developed capital markets and emerging markets and conventional wisdom says that if the correlation between two asset classes is low, you can combine the assets into a portfolio with lower risk than the individual asset class. It is also argued that since differences exist in levels of economic growth and timing of business cycles among various countries, international portfolio diversification can be used as a means of reducing risk.

Financial crisis like that of Great Depression (1929), Asian Market crash (1997), Dot-com bust (2001) and Credit crisis (2007-08) have shown that these are the times when the investor needs the effects of diversification the most and in these times emerging and developed markets tend to be highly correlated. The volatility in the markets affects cross market correlations and after the crash, the co-movements of markets increase significantly, implying that the benefits of international diversification decreased considerably.

Emerging markets had a great decade. Their story was strengthened by the resilience of countries like Brazil, India and China and other Asian economies to the financial crisis which was seen as largely a developed world issue. Looking forward the story remains intact. For many people the future of investing can be summed up in two words: emerging markets. There has been a fundamental revaluation of the relative risks of the larger emerging markets and questions are raised whether the term emerging market is any longer appropriate. Moreover, stock markets across the world are becoming more integrated and it has been found from the studies that correlations have remarkably increased over the time and the incentive to invest in these markets is diminishing.

Another interesting result observed is that correlation coefficients are uni-directional, correlations going from the U.S. to Japan are not the same as those going in the opposite direction. This is due to the fact that trading hours of the markets are different and that the market that opens later typically contains information on what happened in the market or markets that had already closed. This result may indicate that the Nikkei 225 returns are much more correlated with the S&P 500 returns after the close of the U.S. market than would be the reverse case.

Although all the economies move through the various stages of the business cycle over the time, these cycles are not always synchronized across countries (e.g. one country may be in recession while a second country is in early upswing). The degree of synchronization of the economies is increasing over the time as the international capital markets become more integrated. However, it is very unlikely that they will ever be completely synchronized. The key implication of the lack of complete business cycle synchronization for investment analysis is that international diversification of equity portfolios is valuable. This is because, to the extent that country business cycles are not synchronized, global return covariances will be lower and portfolio managers who diversify globally will realize better returns-to-risk tradeoffs and higher risk adjusted portfolio returns.

References:

http://gbr.pepperdine.edu/072/diversification.html

http://www.apexinvestmentguru.com/investmenttalk.php?id=5