We look at some potential reasons why foreign stocks aren't as great diversifiers today as they were in the past.
One reason why investors clamor for international stock exposure has traditionally been the belief that foreign stocks have been reasonably uncorrelated from the U.S. market. The theory is that stock markets in different countries will tend to move in different directions at different times. So if the U.S. market has a period of bad performance, perhaps German, Japanese, or Chinese stocks will be doing better. Over time, this diversification could help smooth out returns and provide better long-term returns with less risk.
But is this view accurate anymore? Are investors really gaining diversification when they look abroad? We looked at the difference in correlation coefficients between the S&P 500 and several international indexes to examine what kind of changes have happened during the last 15 years. Our top-level findings were that correlations, especially in emerging markets, have risen markedly during the time period.
The indexes that we tested were:
MSCI All-World ex-U.S.: Tracks a broad cross section of large- and mid-cap stocks from everywhere in the world except the United States.
FTSE 100: Tracks 100 of the largest stocks traded in the United Kingdom.
MSCI EMU: Tracks large- and mid-cap stocks from countries that use the euro.
S&P Latin America 40: A concentrated portfolio of 40 Latin American stocks.
Nikkei 225: Tracks 225 of the largest stocks traded in Tokyo.