Rethinking diversification - MoneySense

Rethinking diversification

Global diversification should insulate investors against a sudden drop in any one market, but some wonder if it still works


global diversificationThe 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.

Rethinking diversification

So how do investors get back to 1952? That’s the question Stoxx set out to answer. Their solution: create an index that considers not only where a company is based but where it earns its revenues. These indices strip out the international exposure from a local market and create an index that is more reflective of a single country market.

Consider Couche-Tard and Intact Financial—two important components of the S&P/TSX Composite. Apart from where they are domiciled, how Canadian are these companies? While 100% of Intact’s revenues are generated in Canada, nearly 95% of Couche-Tard’s revenue comes from the U.S. and Europe.

The argument suggests Couche-Tard would be more sensitive to those markets than it would be to what’s happening in Canada. That’s just one example. Investors might be surprised to learn that only 55% of the revenues generated by the S&P/TSX 60 companies comes from Canada.

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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.

What does this mean for DIY investors?

Should investors worry about where businesses within an index derive their revenues? Dan Bortolotti, an associate portfolio manager with PWL Capital, is skeptical. This argument has come up before, he says, but he’s not sure if it addresses a real problem. “You can always look back and find strategies that would have outperformed in the past,” he says. Investors need to understand the reason for that outperformance, and decide if they can expect it to continue in the future. “Before we dismantle one of the pillars of investing, I think these questions need to be addressed.”

There are other drawbacks, too. Depending on the country, Stoxx pure country indices may be more heavily concentrated in some sectors while underexposed to others, like tech.

For the interim, it’s a moot point since the Stoxx pure country indices are not currently available in ETF form. The company says it may be another year or more before DIY investors can buy them directly.

But DIY investors building a concentrated stock portfolio may want to look to Stoxx’s indices to help assess geographical diversification within their portfolio. “The users of these are anyone who wants to understand what their real revenue exposure is across developed and emerging markets,” says Jones. Investors can learn more by visiting the Stoxx website, which displays the top 10 constituents of each pure country index.

Bortolotti thinks the True Exposure strategy might make sense if you are trying to get targeted exposure to a particular county’s economy. But he says investors are better off striving for global exposure in their portfolios, and that’s easier and cheaper with traditional index funds. “I would argue it’s good thing that many Canadian companies earn much of their revenue in the US and overseas. Over the long term that kind of international diversification is exactly what you want.”