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Thursday, March 29, 2007

Sense and Nonsense on International Investing







A recent WSJ article focused on international stocksand their role in individuals’ portfolios. As is often the case a small amount of good information was buried within a lot of bad information. The consensus among virtually all financial advisors is that Investors should hold an allocation to international stocks developed and emerging markets in their portfolio. The recommended allocation usually is put between 15 – 30%.

However, the rationale for this allocation has changed over time. Conventional wisdom had been based on the idea that international stocks were not highly correlated to US stocks. This argument, however has been less persuasive over time. As the capital markets around the world become more integrated the the correlation between equity markets around the world has risen sharply. Based on the data most readily availability to me. I made the following comparison between correlations between Jan 1998- Jan 2003 and Jan. 2002 – Jan 2007:

S+P 500 correlation to:

Emerging markets: 1998 -2003: .40, 2002 -2007: .77

Developed International 1998-2003: .44, 2002 -2007: .85

Nonetheless, the case for international investing may be made in light of the fact that the US stock markets make up less than 40% of the world’s market capitalization and therefore a portfolio should have exposure to the global markets. The returns data is listed below, while the recent outperformance of the international stocks is impressive, more academically inclined observers would point out the convergence of returns in the 10 year data.

The returns are listed below


1 Year

3 Years

5 Years

10 Years

S&P 500 Index

11.97

9.10

6.82

7.63

MSCI Emerging Markets Index (gross div.)

17.39

26.84

25.31

8.05

MSCI EAFE Index (gross div.)

21.57

19.53

16.88

8.43

One thing is certain however the international markets are unlikely to “zig” when the US market “zags”. As one market saying goes “the only thing that goes up in a down market is correlation”. A glance at the one year charts of EFA (developed international index) vs the S+P 500 (in brown) on the top right and EEM (emerging international) vs S+P 500 on the top left shows the high correlation. Although the international markets outperformed they all moved in sync with the US market. Remember 2 assets can have very different returns and volatility but still be highly correlated. Two assets that experienced rises and declines of 5% and 10% respectively at the same times would be very highly correlated despite the different returns and volatility. Such is the case in both charts above.


So here comes the good news and the bad news. The good news is that investors are incorporating an international allocation into their portfolios:

U.S. investors are shipping lots of money abroad. Last year, flows to international equity funds, including exchange-traded funds, hit a record $121.3 billion, compared with $86.3 billion in 2005, according to AMG Data Services of Arcata, Calif.

The bad news is that (surprise) investors are market timing their international investments:

But after last month's selloff, these funds lost a net $3.4 billion in the week ended March 7, the first significant negative result from a market decline since last summer. Money flows have turned positive again, at $1.5 billion last week.

And here’s the worse news: brokerage firms are giving individual brokers the “enhanced capability” ( or a loaded gun ) to trade individual foreign stocks. Etrade, Schwab, Fidelity and Interactive brokers are offering clients the opportunity to trade online individual stocks in 34 (!!!) countries at low commissions.

Imo these “new options” for individual investors are simply giving investors a weapon with which to shoot themselves in the foot. The likelihood individuals will outperform global indices with their individual stock picks is very small.

And sure enough the investor overconfidence so well recognized by behavioral economists is in evidence

Jon Wilson, a software consultant in Cedar Rapids, Iowa, says the ability to buy stocks directly on the foreign exchanges was a key factor that prompted him to start trading foreign stocks with Interactive Brokers LLC, a brokerage aimed at professional traders. "It's what buys you real-time transaction capabilities and it's what gets you the least fees," he says.

I can assure Mr. Wilson that “real time transactions and low commissions” while not a bad thing will have next to nothing to do with the long term return of his international stock investing, and that the odds he will outperform a broad international index with his individual stock picks is minimal. After all not only does he have to be right in timing the market, stock selection, and industry selection, he now has to be right on the country as well. And all of this with less data than available for domestic stocks. To say the odds are against him is an understatement.

To its credit the WSJ acknowledges a better alternative is available:

For most investors, though, the easiest way to invest overseas is through U.S. mutual funds with an international focus. Although average annual expenses are typically higher for international funds than U.S. stock funds, the boom in international ETFs gives investors access to lower-cost options.

My next entry will be more specific in describing our approach to international investing

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