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Diversification through global investment

As the world’s economies become more globalised what happens in one country can have a far-reaching effect on the rest of world. Morningstar investigates how investors can construct a globally diversified portfolio to take advantage of international growth while managing risk.

Morningstar.co.uk Editors 14 August, 2001 | 1:50PM
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One of the basic principles of investing is aiming for the maximum reward for the least amount of risk. Therefore a portfolio should be matched to the risk profile of an investor. This means that the assets in a portfolio should work with each other to ensure a consistent level of returns. Diversification of assets is part of the recipe that creates this continuity so the trick is getting this balance right.

One way to achieve such diversification is through international investment. For example, a core portfolio for a UK investor might have a UK equity fund, a UK fixed-income fund and a European growth fund. Perhaps a North American fund for exposure to the US markets would be added. An emerging markets fund or an Asian fund would provide more risk with the potential for greater returns. The key is learning how the countries relate to one another.

Country correlation

Holding a globally diversified portfolio rather than a single country portfolio should reduce an investor’s risk levels. Yet just picking several regions at random will not guarantee diversification. The correlation of various regions – the degree to which countries move in a similar way – varies significantly.

The table below indicates the percentage of correlation for a sample of regions over the past five years based on annual returns in the stockmarkets.

Untitled Document

Regions

Correlation

US and UK

92%

US and Europe (excluding UK)

82%

US and Japan

22%

US and Asia Pacific

19%

Source: Cazenove Fund Management



This means that investments in the US, the UK and Europe will tend to react the same way to economic influences. A downturn in the US economy will generally be followed by a similar move in the UK and Europe but not necessarily in Japan and the Asia Pacific countries.

An easy though admittedly basic guideline for investors is to remember that the Anglo-Saxon economies [US, UK, Canada, Australia] generally move together. The euro-zone economies usually move similarly with a varying degree of correlation between the faster-growing economies like Spain and Ireland and the slower ones like Germany.

But it is important to note that correlations are not fixed. Countries that move together now did not necessarily do so in the past and may not do so in the future. To illustrate, Japan is currently much more affected by global developments than it was in the past.

“Historically Japan has often been able to move in a different cycle because although it had a very strong trade interrelationship, its domestic economy was strong enough to outweigh what was happening on the international side”, says Michael Karagianis, the head of global strategy at Aberdeen Asset Management.

“In the past when the US was turning down, Japan was often actually turning up. Without the vibrancy in its domestic economy it is much more exposed to the global dynamic.”

Economic correlation

There can be a difference between economic correlation and market correlation. The correlation of the economies of two regions can be low yet the market correlation can be high especially when the stockmarkets are volatile. For example, the effects of a volatile US domestic market can affect other markets in a similar yet more subdued manner even if their economies may be doing something different.

“We tend to find that economically Europe lags the US by about six months”, says Mr Karagianis. “A few months ago people were assuming that Europe was immune to what was happening in the US but now they are aware that it was simply the lags working themselves through.”

“Market-wise the turning points we saw in the US equity [stock] markets in terms of sectors and aggregate market performance have been pretty much picked up by the European market at about the same time.””

Yet the effect of an event is strongest in the original country. For example, an interest rate cut in the US benefits the American consumer the most and then the gain is rippled through to the UK, Europe and so on.

Fund types

Because investors have a choice of different types of funds within each economic area – a Japanese growth fund will act differently than a Japanese income fund – it adds another dimension that makes country diversification more complex.

“Correlation among funds must be judged on a case-by-case basis based on what is actually in the portfolio”, says Luca Polenghi, a quantitative analyst at Invesco Perpetual,

The importance of knowing the aggregate holdings of a portfolio is heightened because straightforward comparisons cannot always be made.

Taking this one step further are cross correlations where the economy of a country will correlate closely to a sector.

“You might find that the Japanese market overall is highly correlated with global basic industries or global consumer cyclicals”, says Chris Iggo, a global strategist at Cazenove Fund Management. “The US has been very highly correlated to technology. Places like Canada and Australia would be highly correlated with resources because they tend to be large producers of basic materials.”

The globalisation of the world’s economies is on the increase with the growth of internationalised trade and investment. A Spanish company may have assets all over Latin America while a UK company could have subsidiaries across the globe. The growth of such ties may increase the correlations between countries and even countries and sectors. Yet the consensus amongst the experts Morningstar interviewed is that the need for geographical diversification remains.

Overall investors should remember that countries do correlate and some more than others. Geographical diversification is key but still just one part of diversification which also includes opportunities to balance a portfolio through sector and asset choices.

For a complete picture of how a portfolio is balanced, run it through the Morningstar Portfolio X-Ray. Investors can add funds and change around the weight of each fund to get the best balance for their risk profile.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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