Do international index funds still offer diversification benefits?

I know the academic line is that there is a diversification benefit… but it seems that with globalization, world economies have become increasingly more and more interconnected (i.e. correlated) – thus largely blunting their diversification benefit.

Even Warren Buffett has suggested that the average person would best be served by just a portfolio of 90% in an S&P 500 index fund and 10% in short-term bonds (no mention of any international exposure).

Do you think that international equity exposure is still a necessity for proper diversification?

Pretty sure they aren’t that correlated. US Stocks have been on a tear while the rest of the world is, well, mixed.

I think you are thinking about times of extreme stress when correlations converge. And yes, that’s probably true more and more.

specfically, when shit goes down all correlations go to 1. cuz errything goes down.

except China. but China never goes up so what’s the point?

Yeah, this is an important point. Most people - advisors and retail investors specifically - don’t understand what diversification means. In 2008 everything went down due to market risk; diversification can’t help you there (unless we want to start talking about alternatives again). A well diversified portfolio can still insulate investors from various factor risks like cap size, sector, style, country, currency, political, etc…Just because a well diversified portfolio still lost a huge chunk of change in 2008 doesn’t mean diversification is dead, or that everything is now highly correlated (it hasn’t been for a couple years).

For those that are interested. Webinar happening today:

Correlation Risk and Why it is Critical in Finance : http://www.garp.org/risk-news-and-resources/webcasts/upcoming-webcasts.aspx

Also, I think it was also function of a “global” bubble. Just like economic shocks before were always regional in nature in the USA. I think the world just went down hill because a lot of chain linked events. That’s not even a normal stress event, that’s the 3 sigma event. But they do seem to be getting more common

If the international fund is in USD, diversification is limited. There is a push to get international funds in the local currency to get both the dollar and investment edge.

^This.

I wonder if you could separate the fund return into “return in the local currency” and “appreciation of the local currency”, I would guess (based on zero research) that the difference in returns is almost exclusively due to currency fluctuations.

Um I really can’t see how that makes sense. The economies of different countries are at much different stages, have different valuations, have different drivers, etc. This is risk free government bond funds. . .

^I assumed (maybe wrongly) that we were talking about a fund that invested in diversified, yet developed markets. (Western Europe, Canada, and Asia.) That’s what I think of when I hear “international fund”.

Brazil, Russia, India, China, and South Africa are what I call “emerging markets” which is distinctly different.

Vietnam, Egypt, Zimbabwe and Nigeria are what I call “frontier markets” and will obviously be in a different economic stage than the others.

In terms of performance attribution, you most certainly can separate the performance of the local currency market and the currency appreciation, which can be useful for diagnostic purposes.

Whether you can invest in that is trickier. In fixed income, you can hedge out currency because (for many kinds of FI securities), you know what payments are due when, and can enter derivatives contracts in the right amounts to neutralize currency effects. However, with equities, this isn’t really possible, because the values fluctuate too much. The best you can do is a “sloppy hedge” where you make some estimate about average equity appreciation rates, hedge that currency amount, and hope you’re not off by too much. Or you find a bank to take on the risk for you, but that’s almost guaranteed to be more expensive than it’s worth, or the bank would never take the other side of the deal (however, if you are far more risk averse than the bank, you might still see a benefit that you couldn’t realize on your own).

The last time I did the research, international equities still provided diversification benefits, particularly emerging markets, but the degree of benefits are lessening over time because of globalization and financial liberalization. It is possible that as countries face increasing political pressure to set up capital controls in a post-crisis world, international markets will become somewhat more segmented and diversification benefits will improve, but thus far we haven’t seen it.

Remember that diversification protects against ideosyncratic or non-systemic risk, so the idea is that a diversified portfolio is more efficient in converting your willingess to take risk into expected returns, because you won’t be paying for risk that is just as likely to outperform as underperform over the long term. It does not mean that you won’t have systemic risk (which is basically the risk of things going bad when everything else is bad too). The only way to neutralize that is to hold a different asset, like cash - which exposes you to different risks.

The other thing about diversification is that low correlation isn’t the only thing that matters. You still have to have a sharpe ratio high enough to make the asset a valuable addition to the portfolio. In a diversification context, that sharpe ratio doesn’t have to be enormously high, but it must 1) be positive, and 2) greater than the sharpe ratio of the original portfolio times the correlation between the portfolio and the asset.

If you are adding an asset with a negative sharpe ratio to a portfolio, you’re either 1) hedging, or 2) being dumb. If you’re hedging, you’re doing that because there is a specific risk that you’ve identified that you don’t want exposure to.

I meant to say isn’t in regards to foreign gov bonds. There is probably more of it being currency in developed, but even that wouldn’t make sense to me. Different countries have different industries, liquidity, etc.

Nearly all non-U.S. equity funds are unhedged. It makes zero sense to own a hedged int’l fund. On the fixed income side things are a little different though.

That’s right – specifically the two ETFs that I was questioning were EFA (tracking the MSCI EAFE index) and EEM (Emerging)

When you take Level 3 (If you pass Level 2 that is), you will see why this is wrong.

^No. Despite what the CFA teaches, during a panic, everyone sells everything, and thus, correlations are ~1.

The CFAI Level III material gives a nod to increased correlations in times of stress in their discussion of Financial Contagion.

Can you elaborate? Note that CFA L3 covers hedging vs not hedging (in limited detail) so you can assume I know that material.

WisdomTree offers several currency-hedged ETFs that are popular, not that it is always a popularity contest.

Well, I shouldn’t say there’s never a place for them. I would use a hedged product if I had a very specific thesis on that country/region/whatever and I didn’t want to mess with the currency risk. But, your average Foreign Large Blend fund is being used in an asset allocation model. Keeping it unhedged makes it a better portfolio diversifier. If you think about it, most of your assets are in USD - house, car, the majority of your 401k/IRA - and you’re paid in USD. For true international exposure you have to have that currency risk in there. It protects against the huge amount of USD risk you already carry (but most people don’t think about).

The other question, if you ask me, is whether you would want to invest outside the US in the first place at the moment.