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Investors who do invest internationally often make two mistakes that limit their ability to profit from non-U.S. investing. These mistakes reinforce—and to some extent, perpetuate—the belief that investing outside the U.S. is not as attractive as it truly is. The first mistake is that investors don't allocate enough money to international portfolios. The second mistake is that they fail to adequately define the international equity asset class and exclude important regions and countries that would otherwise boost returns. The persistent home-country bias and incomplete exposure in U.S. portfolios truncates the opportunity set for most investors and limits their ability to profit from long-term structural changes in cross-border production and consumption patterns. There are several compelling reasons to include or even increase international equity allocations in investor portfolios. Furthermore—and also contrary to conventional wisdom—the most effective method for obtaining core non-U.S. exposure lies in index-based strategies. These approaches include both passive and enhanced index strategies. Putting an effective index-based program into action involves understanding the appropriate definition of beta for non-U.S. allocations and applying a similar risk-budgeting framework to support core domestic allocations. Finally, where active international equity managers are utilized, potential style risks should be assessed and measured. For example, if a plan's active managers are mostly adapting value-based investment approaches, then a growth element might be missing from the overall international allocation. Once identified, such "risk holes" can be plugged by using an index-based international growth strategy. International Equity Allocations Dramatically Lag Growth Opportunities While the long-term performance comparison between the U.S. equity market (as measured by the S&P 500) and international equities (as measured by MSCI EAFE) marginally favors the U.S., the advantage is tipped by the relatively brief period in the late 1990s when the technology/telecom mania prevailed. As shown in Figure 1, from December 31, 1969 through January 1995, international equities outperformed U.S. equities by almost 400 percent cumulatively. From January 1995 through August 2000 (the peak in the S&P 500), the markets reversed, with international equities underperforming by 180 percent. Since that time, international equities have once again outpaced domestic stocks, posting 16 percent higher returns for the period since the peak of the bubble through the end of 2004.
To meaningfully participate in global economic growth, investors simply cannot afford to restrict their investment universe by corporate domicile; to do so overlooks 95 percent of the world's population and 80 percent of world GDP (see Figure 2). Many of the larger emerging markets such as India, Brazil, China and Russia are seeing a huge rise in the ranks of their middle class, which is fueling a boom in domestic demand—these economies are not simply driven by export-led growth, as has historically been the case. Furthermore, a number of world-class companies such as Samsung in Korea, Embraer in Brazil, Cemex in Mexico, InfoSys in India and dozens of others are domiciled in emerging markets yet are major global players in their industries. This latter trend is likely to accelerate, including the prospect of more takeover attempts by emerging market companies, as illustrated by bids for Maytag and Unocal in the summer of 2005 by China's Haier and CNOOC, respectively.
Concerns expressed over the course of the first part of this decade that diversification benefits were being eroded away and that volatility was permanently higher have proved incorrect, as correlations have flattened and volatility increases have reversed recently. Furthermore, as will be discussed later in this article, the diversification available through weak correlation is enhanced by a broader and deeper definition of the international equity asset class. Investor concerns about the implicit risk of currency fluctuations that come along with exposure to foreign securities are similarly misplaced. The fact is that part of the benefit of investing internationally is obtaining diversified currency exposure, as this is a significant component of the overall return of international investment. Approximately two percent of the total annualized performance of MSCI EAFE, or half of the cumulative return since 1969, can be attributed to currency movements. Perhaps this is why many institutional investors who used hedging programs had disappointing aggregate performance from their international equity exposure, laying a foundation for some of the skepticism about international equities that emerged in the late-1990s and early 2000s.
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The widespread belief that international equities can improve a U.S. portfolio's risk/return profile has lost some support both from investors and academics in recent years. Some market observers point to greater correlations between non-U.S. and U.S. markets as evidence that the diversification benefits from investing abroad have eroded and therefore do not warrant the perceived additional risks. This newfound skepticism about the benefits of international diversification has worsened a problem afflicting U.S. investor portfolios for decades: the systematic underweighting of international stocks.
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