Diversification

Diversification, whether across asset classes or within them, is widely regarded as the only free lunch in investing.  Over time, a diversified portfolio offers better risk adjusted returns than an undiversified one.  We have no quarrel with this concept.

One area where diversification has a prominent role within the equity component of portfolios is where it comes to dealing with the issue of “home country bias”.  A globally diverse portfolio offers better diversification than investing solely in your domestic market.  This is especially true when the home market is dominated by just a couple of major sectors such as resources or banking.  Again, no quarrel here.

However, let’s say you’re a UK based investor and you want to diversify away from the UK market.  Let’s say you look across the Atlantic and see lots of excellent opportunities in the US market.  How much should you allocate relative to your home market?  Let’s say you’re really bullish on US equities.  The same?  Twice as much?  You really like this market – 10 times as much?  Let’s say this is the best opportunity you’ve ever seen.  How about 19 times as much?  Congratulations, you’ve just bought an MSCI World tracker.

Source: Bloomberg

The nature of the investment management industry is that benchmarks drive allocations.  Career risk dictates that material deviation from benchmarks for most managers is minimal.  Hence, practically speaking, international diversification in this context simply means swapping one home country bias for another, as the US makes up 70% of the benchmark.

For at least the last decade, this has paid off handsomely.  The US equity market has trounced other developed markets driven in large part by the tech behemoths.  This has made benchmark driven international investing look pretty smart.  But what about for US investors?  Presumably the merits of international diversification apply equally to them, yet the impact has been much less favourable.

There is also a reflexive component to consider.  As overseas money flows into US markets (as they must, to balance huge current account deficits that the US runs) they help to drive up the prices, increase the weighting in global benchmarks and the cycle repeats.  However, trees don’t grow to the sky.  The high concentration in the big tech names, the so-called “magnificent seven” has grabbed all the headlines but look just a little deeper and there are some lofty valuations.  Costco for example trades on over 50 times this year’s earnings.  It’s growing at roughly 10% but even so, it is after all, a supermarket.  The prospective returns for today’s investor feel meagre, at best.

Recency bias dictates that the tendency is to address these risks after they have manifested themselves in prices.  However, investors should be aware that their “internationally diverse portfolio” could just as accurately be described as a concentrated bet on one the most expensive markets in history.