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Global diversification should insulate investors against a sudden drop in any one market, but some wonder if it still works
The value of diversification in investing is well documented. Nobel Laureate Harry Markowitz stressed its importance when he introduced his Modern Portfolio Theory in 1952. At the risk of oversimplifying his theory, diversification works because assets are not perfectly correlated, which ultimately smooths out investor returns. It’s been the bedrock of sensible financial plans ever since. But does it still work?
No one is suggesting Markowitz’s theory is wrong, but there is a debate about whether it is still as effective, at least from a geographical diversification perspective. Without question, global markets have changed dramatically since 1952. “It just doesn’t work anymore,” says Rod Jones, managing director with Stoxx Ltd. The typical indices that most people use don’t do what people want them to do, he says.
Consider what global markets looked like 65 years ago. Multinational firms were rarer and markets in different countries largely acted independently from each other. Large multinationals now dominate the major indices, while goods and services flow freely across borders. Pull apart most balance sheets of any large company and you’ll likely discover a significant portion of their revenues comes from somewhere other than their home country.
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The new Stoxx True Exposure Index Family takes this into account. Companies that earn a certain percentage of its revenues abroad are knocked off the index. (Stoxx offers varying four versions of its indexes for each country, with varying degrees of international revenue exposure.) But does it make a difference? When you compare the performance of these pure-country indexes to the traditional indices operating in the same market a trend emerges. Over the past decade the STOXX Canada TRU 100% Exposure Index would have returned 6.56% on an annualized basis, whereas the S&P/TSX 60 yielded 4.64%. They also claim volatility drops with their pure country indices, which helps with compounding over time. The real advantage to holding these indices might be when global markets hit some turbulence, says Jones. While international markets may not rise at quite the same rate, when they fall they tend to fall in lock step. The financial crisis of 2008, the selloff in China’s stock market in 2016 and the initial reaction to Brexit were local market events, says Jones. And yet the broader market in Canada and the U.S. sold off as well, even though they don’t have that much exposure to China. He says a pure country index wouldn’t have been affected as much.Share this article Share on Facebook Share on Twitter Share on Linkedin Share on Reddit Share on Email
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