Global diversification

From finiki
Jump to: navigation, search

Global diversification is a type of geographical diversification that consists of adding foreign asset classes, such as stocks and bonds, to a domestic portfolio. The goal of global diversification can be to increase the expected return, decrease the risk, or both, although whether such goals will be achieved cannot be known in advance. This page explores the pros and cons of global diversification for fixed income and equities, from a Canadian perspective, but first explains the "home country bias" phenomenon.

Home country bias

Main article: Home country bias

A home country bias is the tendency for investors to focus their investments in their domestic markets.[1] Financial theory suggests that investors should construct their asset class exposure in line with global-market capitalization.[2] Canadian equities represent 3% of world stock markets at the end of 2013,[3] and 4% (as of November 28, 2014)[4] of developed market countries, excluding emerging markets. Similarly, Canada represents 2% of the world's fixed income markets.[5] Canada is the sixth largest stock market by capitalization and the bond market ranks in the world's top ten.[3]

According to the most recent survey from the International Monetary Fund, Canadian investors only allocate about 40% of their total equity investments outside of Canada[2]. While this represents some understanding and commitment to global diversification, it overweights Canada and underweights the rest of the world's capital markets.

Impact of currency exposure

Main article: Currency hedging

Global diversification brings foreign currency exposure into the mix. Canadians generally are well aware of the range of fluctuation of the Canadian dollar versus the US dollar, particularly in the short term. Over the longer term, currency fluctuations tend to average themselves out and therefore reduce the impact of currency exposure.

Global diversification in equities

Each investor has to evaluate the pros and cons of global diversification for equities, taking into account his/her personal situation, but the arguments in favour of at least some global diversification for equities seem convincing. Nevertheless, Financial Wisdom Forum members have indicated allocations to Canada ranging from 0% to 100% within the equity part of their portfolios, showing that different approaches can work for different people.

Arguments for global diversification

  • The Canadian stock market is highly concentrated in three sectors (energy, materials, financials) which are quite cyclical, and has significant under-representations in information technology, health care, consumer staples and consumer discretionary[5], relative to the rest of the world. See diversification.
  • Issuer concentration. The Canadian market has 36% of its capitalisation in the top-ten stocks[2], compared to 17% for the US market[5]
  • Global equity diversification can reduce the volatility of returns because the correlations coefficients between Canada and global stocks are less than one (rolling 36-month correlation coefficients have varied between 0.37 and 0.87 over the period 1972-2014[2]). More on this below.

Arguments against global diversification

  • The dividend tax credit applies to Canadian stocks but not foreign ones (relevant for unregistered accounts only)
  • Apart from the US and parts of Europe, there may be corporate governance issues for overseas companies[5]
  • (Historically) high costs to access foreign securities [5]
  • Multinational companies provide international diversification[5] (although this seems to work better for US or German investors than for Canadian investors[6])

Implementation

Global equities are typically divided into US equities, international equities and emerging markets; these articles suggest ways to access these asset classes using exchange-traded funds (ETFs), index funds, and perhaps individual stocks. One-ETF-solutions for global equities (i.e., equity funds covering the whole world except Canada) are mentioned in Simple index portfolios: three ETFs.

For a "balanced" portfolio, an easy approach is to split the equities into three thirds: Canadian equities, US equities and international equities; this is what the model portfolios at Canadian Couch Potato do. Investors preferring a stronger home bias may instead divide the equities into half Canadian and half global, for example: this is what the FPX indices do.

Global diversification in fixed income

For fixed income investments, it appears that avoiding global diversification (i.e., keeping it all domestic) is largely justified for most Canadian investors: the "cons" largely outweigh the "pros". One exception may be for large bond-heavy portfolios, as explained in foreign bonds.

Arguments for global diversification

  • Adding some foreign bonds to a bond-heavy portfolio would theoretically lower its volatility (see below)
  • Lowers the "country risk" related to investing most of one’s assets in a single country, even a developed and stable one like Canada

Arguments against global diversification

  • Keeping all fixed income domestic is more simple, and avoids higher management expense ratios (MERs)
  • Better investor knowledge of domestic markets
  • Foreign bonds imply exposure to foreign currencies, which would add greatly to the volatility of fixed income investments; hedging the currency exposure is possible, but adds to costs
  • The domestic (Canadian) fixed income market is well diversified by issuer type (federal government and agencies, provinces, municipalities, corporate), term (short, medium, long), and credit rating (see Canadian vs. global bonds), so there is no need to venture elsewhere
  • The domestic market has historically provided returns and volatilities comparable to developed markets as a whole[note 1]

Reducing portfolio volatility

Portfolio theory predicts that mixing two asset classes with similar risk-return characteristics, but imperfect correlation, can reduce portfolio volatility. This means that adding global stocks, or foreign bonds, to a portfolio of Canadian stocks and Canadian bonds, should theoretically lower its volatility. We first examine this effect for equities, and then for fixed income.

Adding global stocks

We construct hypothetical portfolios of bonds (asset class B), domestic stocks (asset class S1) and global stocks (asset class S2). Which bonds it is does not matter (could be domestic or foreign), but in most Canadian portfolios it would be domestic bonds. Let’s assume the following characteristics:

Asset Annualized return Standard deviation
B (bonds) 4% 6%
S1 (domestic stocks) 7% 17%
S2 (global stocks) 7% 17%

Note that domestic and global stocks are assumed to have the same expected annualized return and standard deviation (a measure of volatility). We have not chosen a different expected return or standard deviation for domestic versus global stocks in order to avoid sterile discussions about which particular domestic-global stock mix is the best. We just can’t know in advance what the best proportion will be, so we’ll use an equal mix of domestic and global stocks, and compare that with domestic stocks only, or global stocks only.

The two bond-stock pairs (B-S1 and B-S2) have hypothetical correlation coefficients of zero, whereas the two stock classes have hypothetical correlations ranging from 0.4 to 0.8.[note 2] In this section we concentrate on stock-heavy portfolios (70%), which will benefit the most from global diversification, but even at 30-40% stocks global diversification seems warranted.

Refer to the following figure. The black curve (right-most) is a mix of bonds (B) and one stock class (S1 or S2), whereas the coloured curves include the two stock classes, equally weighted, with variable coefficients of correlation. [note 3]

Bond-Stock1-Stock2.jpg

Let’s look at the black curve first. This represents the equivalent of a two-fund portfolio of Canadian bonds and Canadian stocks only (or Canadian bonds and global stocks only). Using the expected returns listed above, a portfolio of 70% stocks (30% bonds) has an expected return of 6.1% with a relatively high standard deviation of 12.0%. If the distribution of returns follows a normal distribution, then one year out of six, the portfolio will loose about 6% or more. Every 44 years, the portfolio will loose 18% or more.

The blue, green and red curves (right to left) add global diversification to the picture. They represent mixes of bonds (B) and stocks (S), but the stocks are now divided equally between S1 and S2 (domestic and global). At 70% stocks, this global diversification reduces the standard deviation by 0.6% for a 0.8 correlation between S1 and S2; by 1.2% for a 0.6 correlation; and by 1.9% for a 0.4 correlation, bringing the standard deviation down to 10.1% instead of 12.0% for the two-asset portfolio. The expected return, meanwhile, remains unchanged at 6.1%. This reduction in portfolio volatility seems very worthwhile.

At stock proportions of less than about 25%, global diversification of stocks does not change significantly the expected return and standard deviation on the graph: one stock class is essentially the same as two. Instead, at these low stock proportions, the investor may have to turn to foreign bonds, or real-return bonds, for diversification.

Adding foreign bonds

This time we will mix two types of bonds (B1, B2) with one type of stock (S). The S component, assumed to be domestic (but it does not matter, it could be global), is as above (6% return, 17% standard deviation). The two bond classes, assumed to be respectively domestic and foreign (with currency hedging), have the same returns and standard deviations as those used before (4% return, 6% standard deviations). The B1-B2 correlation is set arbitrarily at 0.8, based on the range of 1993-2013 correlations between different types of Canadian bonds and US bonds. We compare bond-stock mixes using one bond class only (B1 or B2) with mixes that integrate the two bond classes, equally weighted.

Bond1-Bond2-Stock.jpg

At first glance, the difference between the black curve (one type of bonds only) and the red curve (B1+B2) is modest, and non-existent above 30-40% stocks. Zooming-in on bond-heavy portfolios, there is a small reduction in standard deviation at stock allocations ranging from 0% to 30%. For example, at 10% stocks (i.e. 90% bonds), the standard deviation decreases by 0.3% (from 5.7% to 5.4%). Other types of developed market foreign bonds may have lower correlations with Canadian bonds, but we don’t have the data to test this. Readers will have to decide such a small potential diversification benefit is worth it, considering hedging costs, higher MERs on foreign bond ETFs, etc.

Notes

  1. For example, during the period 1993-2013, Canadian bonds returned 7% annualized with a standard deviation of 6% (data source: Libra Investment Management), whereas US bonds (hedged to CAD) would have returned 6% annualized, with a standard deviation of 5% (data source: Barclays US Aggregate Bond Index annual returns from the Bogleheads wiki).
  2. The correlation matrix is constructed as:
    B S1 S2
    B (bonds) 1
    S1 (domestic stocks) 0 1
    S2 (global stocks) 0 0.4 to 0.8 1

    This matrix is based on the approximate correlations coefficients between All Canadian bonds, Canadian stocks (S&P/TSX Composite) and several types of foreign stocks (S&P500, MSCI EAFE, Emerging markets) for the period 1993-2013, using data from Libra Investment Management.

  3. Each marker on the curve represents a 10% change in allocation. The curve terminating in "B" is 100% bonds / 0% stocks. The curve terminating in "S" is 0% bonds / 100% stocks.

See also

References

  1. Home Country Bias Definition | Investopedia, viewed January 1, 2015.
  2. 2.0 2.1 2.2 2.3 Pakula et al., Vanguard research, Global equity: balancing home bias and diversification - a Canadian investor perspective, July 2014, viewed December 29, 2014
  3. 3.0 3.1 Credit Suisse Global Investment Returns Yearbook 2014, viewed January 1, 2015.
  4. MSCI World Index Fact Sheet, viewed January 1, 2015.
  5. 5.0 5.1 5.2 5.3 5.4 5.5 Philips et al., Vanguard research, The role of home bias in global asset allocation decisions, June 2012, viewed Dec. 29, 2014
  6. Rowland, P.F., Tesar, L.L., 2004, Multinationals and the gains from international diversification, Review of Economic Dynamics 7:789–826 (PDF)

External links

Financial Wisdom Forum discussions