Archived Article

Revisiting International Investments
    By Jim Martin, President, Arbor Investment Advisors, July 2002

American investors are significantly underweighted in foreign stocks. While American corporations constitute just 47% of the total value of worldwide equities, US fund investors allocate nearly 90% of their equity portfolios to American stocks. ⁽¹⁾

And we're not alone. In a recent study by Merrill Lynch, professors Norman Strong and Xinzhong Xu found that this home bias exists in every major global market; investors and managers favor their own countries.

Is this a case of parochialism or is there evidence to suggest that investors are smart to underweight the rest of the world in their portfolios? The academic evidence clearly suggests that expanding an equity universe to include all stocks globally increases returns and reduces risk.

Non-US markets have certainly grown as a percentage of total capitalization (see Chart 1). Projecting this trend into the future, US markets could constitute less than one-third of global equity capital by 2030. A US investor holding only a token amount in foreign equities in such an environment is making a significant bet that these securities will under-perform in the future. Such an assumption has major implications for portfolio performance.

What do we mean by International equity? Investment professionals generally use the MSCI EAFE Index to represent developed country investments. So for purposes of this discussion, we are looking at the countries in Europe, Australia, Asia and the Far East as shown in Chart 2.

Although there is much discussion about emerging markets, they are relatively small amount of equity capital in the world's developing countries. While potentially good investments, these stocks in all of Southeast Asia, South America and Africa make up less than three percent of world equity capital and should be considered a separate asset class.

Neither are we speaking of global funds–which include US stocks–nor multi-national stocks which are based in the US.

When we speak of International equities, we are talking about major global corporations–which just happen to be domiciled outside the US. As you can see from Chart 3, the market capitalization of the top eight companies in the EAFE Index are valued at over $1 trillion dollars.

There is little evidence to argue omitting these from an investable universe. So why the persistent underweighting by US investors? There seem to be three primary reasons: provincialism, recent investment returns and a perceived decreased diversification effect.

Provincialism. First, it is human nature for us to feel more comfortable with the known: the corporate names and products in the US are just more familiar to American investors. However, this has certainly changed, as US consumers now purchase a significant percentage of goods and services from firms domiciled outside of the US.

A subtle but more powerful bias is a general feeling of US business superiority–that US ingenuity and innovation will always prevail.

Certainly, many technological innovations of the twentieth century have come from the US. However, we need to objectively view the important contributions made from other nations. Also, technology, once exported, is rapidly diffused. One only has to look at the corporate successes in Europe and Asia based on the transfer of original American innovation to see this.

Finally, Americans have been rather smug about security in the past. We have believed that the rest of the world is a dangerous place and that our rule of law and system of strong securities regulation makes the US a safe haven for corporate investments.

Recent events, highlighted by September 11th, and the Enron/Anderson episode have pointed out that this fortress America simply does not exist for investors.

Investment Returns. Investors may also tend to underweight International stocks because they have underperformed in recent years. Chart 4 shows that over the past twenty years International equity returns were high in the late eighties. In the past decade non-US equities generally lagged returns in the booming US stock markets. It is natural for investors who have watched their International investment performance trail to question continuing this exposure.

However, we know that there's a tendency for asset classes to go through cycles. This regression to the mean is a fact of investment life. Since markets are basically efficient, once they move out of a normal relationship with each other, they tend to eventually move back. Successful investors often use a contrarian approach to take advantage of undervalued assets by rebalancing during those down cycles.

Decreased Diversification Effect. A central argument for including foreign stocks in an equity portfolio has always been the diversification principle: When another asset class is added which does not move in lock step with US equities, the result is higher returns and reduced volatility.

As the US and foreign markets have tended to move more in concert in recent years, some investment observers have suggested that this reduces the diversification value of International stocks.

Ernie Ankrim, Director of Portfolio Strategy for Frank Russell Company, has pointed out that while the correlation between these markets has increased in the nineties, the diversification effect is still significant and that any recommendation to reduce International exposure is really market timing or performance driven.

Recommendation. We believe investors who own International stocks should remain committed to this asset class and continue to rebalance to original targets. We further suggest that most investors consider increasing International equities as a portion of their total portfolio. Up to one-third of total equities in International stock is a reasonable allocation to consider.

This is not an overweighting. Based on total capitalization: this is simply moving more toward equal weighting. (Note that since International stocks are more volatile than US equities, investors probably should not adopt a full capitalization equal weighting.)

Also note that this is not a market timing decision; it should be done as part of a long-term strategic decision.

Return to top

Return to Articles page