Do Foreign Stocks Really Diversify?

Note: This video is part of Morningstar's May 2015 International Investing Week special report.

Jason Stipp: I'm Jason Stipp for Morningstar. Investors often pay close attention to correlations between foreign and international securities as they are diversifying their portfolios, but what is that data telling us today and what should we take away from it? Joining me with some insights is Christine Benz, our director of personal finance.

Christine, thanks for being here.

Christine Benz: Jason, great to be here.

Stipp: You recently dug into correlation data. You dug pretty deeply into the correlation data actually, and you have some interesting findings. But let's talk about what some of the data is actually telling us today. So, the correlations really help us measure if [different types of investments] move in the same direction or if they move in different directions. So, let's start with U.S. and foreign stocks. The historical argument is that [stocks that are domiciled overseas] offer you additional diversification. What's the data telling us, though?

Benz: When we look at historical data about correlations, what we see is that they have generally been rising over the past several decades--the correlations between U.S. and foreign stocks. And over the past decade, U.S. stocks and foreign stocks are pretty closely correlated so that when one type of market moves up, the other does as well and vice versa when things are going down. So, that's something that perhaps calls in to question the idea of foreign stocks as a diversifying vehicle. We also see, even when we drill into different investment styles--say, foreign small-cap stocks--what we see is that the diversification benefit isn't appreciably higher than is the case with foreign large-cap stocks versus U.S. large-cap stocks. So, I think this is a pretty intuitive finding. We live in a global world where you've got companies responding to similar forces, and companies themselves are increasingly global. So, they are selling their wares into not just the markets in which they are domiciled, but also into foreign markets. So, it's only natural that things would start coming together as they have.

Stipp: Quite a large percentage of the S&P 500 company sales, for instance, do come from overseas--

Benz: Absolutely.

Stipp: So, there is exposure through there. What about world-stock funds and U.S.-focused stock funds or portfolios? There is overlap there because world include U.S., but their correlations are tighter as well.

Benz: They're very tight. In fact, if someone is looking to a world-stock fund to deliver diversification relative to a U.S.-focused portfolio, they are probably not going to get it--which is not to say you shouldn't look to world-stock funds. I think there are a lot of great managers who operate in that particular space; but from a diversification standpoint, it doesn't appear that there is a strong benefit to, say, bolting on a world-stock fund to a portfolio that's primarily anchored in U.S. equities.

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Stipp: So, we have seen correlations between U.S. and international getting closer, but in recent times, we have seen a little bit of divergence. What's going on there where we're starting to see some differences in performance?

Benz: It's interesting. Over the past three years, you can see that the correlations have actually spread out a little bit, certainly, from where they were five or even 10 years ago. One of the big reasons that we have seen the wider correlations between foreign and U.S. stocks, I believe, is currency-related. So, we've seen the dollar appreciate at the expense of the euro and the yen, and that has caused correlations to widen out. It appears that there has been a better diversification benefit for investors holding foreign stocks. Of course, the performance hasn't been as good on their foreign-stock holdings, but perhaps, in terms of improving the risk profile of their portfolios, it does appear that there has been some merit.

Stipp: What about if we look at emerging markets? People tend to think that this is quite a different area of the world--different risks and different rewards. How do those stack up, correlation-wise, against U.S.?

Benz: We tend to see rising correlations there as well, although they have diminished a little bit over the past three years. Correlations are pretty tight between U.S. large caps and emerging markets.

Stipp: When you are trying to use this data to diversify a portfolio, what should we make of this? We're seeing a little bit of divergence starting here between U.S. and foreign. Is that something we should bank on or how should we use it to build a portfolio?

Benz: Not really. In fact, I think when you look over the history of correlations, what you see is that, oftentimes, they're not terribly predictive. Here's a great example: Commodities investments were really sold as this great diversifying tool in the second half of the 2000s; a lot of investors added them to their portfolios, and then in the financial crisis, commodities really didn't deliver at all. In fact, in many cases, their results were worse than what investors had from their equity portfolio. So, I wouldn't bank on correlations either continuing to widen out or continuing to narrow. I think it's probably safe to say that, over very long periods of time, we will see the correlations between U.S. and foreign stocks continue to narrow.

Stipp: One thing that further diversification can bring you, though, is some relief from that idiosyncratic risk of a certain stock in your portfolio doing poorly. If you hold more stocks in more places of the world, you can mitigate that risk.

Benz: That's right. Just because the diversification benefit isn't especially clear from a correlation standpoint, it doesn't mean that having more holdings in your portfolio isn't a good thing. In fact, one key reason that you might consider foreign stocks is that by not including them, you're shutting yourself off to some really world-class companies. So, even though correlations don't make a clear case for having foreign stocks, it doesn't mean you should ignore them.

Stipp: Let's talk about bonds, foreign bonds and emerging markets bonds--or maybe start with world bonds and some of the emerging-markets bonds. They seem to have a little bit more diversification benefit.

Benz: They show a little [more diversifying benefits], certainly relative to a U.S. equity portfolio. That stands to reason, too, because they are bonds, right? It is a different asset class. Not only are they from foreign countries, but they are also bonds. So, they do look a little better from the standpoint of diversifying a portfolio.

One thing we see is that world-bond funds tend to be a little more closely correlated with U.S. bond funds. Emerging-markets funds tend to be a little more closely correlated with U.S. equities and less closely correlated with U.S. bonds.

Stipp: So, [emerging-markets] bonds and U.S. bonds have some different diversification benefits when you are looking at it that way.

Benz: That's right.

Stipp: The other thing to keep in mind is that there are different types of funds, and they invest in different types of debt, and that can provide different levels of diversification. Some will look at dollar-denominated [debt] or some will look at government [debt] and some will focus on corporates, for instance. And that's something else you need to keep in mind.

Benz: That's what makes drawing conclusions about the diversifying benefits of world- and emerging-markets bond funds so difficult, because both of these are very broad baskets, as you say, and the hedging policy of the fund is a huge differentiator. Generally speaking, the unhedged products will deliver greater diversification benefits, certainly relative to a U.S. bond portfolio. The problem is they're also much more volatile. In fact, a lot of researchers in financial planning say that, because they are so volatile, the unhedged products really don't deliver what a lot of investors look to their bond holdings to do for them. So, that's something to keep in mind--that there are huge disparities, huge distinctions in strategies, and that can lead to huge discrepancies in terms of volatility profile.

Stipp: So, [that's especially true] if you are looking at something like a fund that specializes in emerging-markets corporate bonds where there's even more risk. Yes, it may perform differently, but you're also taking on that extra risk.

Benz: Right. And emerging-markets corporates does appear to be one area where I think the diversification case, at least looking at historical data, does appear to be a little bit better. But there, again, you are slicing things that much more finely, and you are opening yourself up to potentially that much more volatility. So, that's something to keep in mind.

Stipp: So, interesting data, some interesting trends. If I'm trying to pull all of this together and make some diversification decisions for my portfolio, what are the main takeaways I should keep in mind?

Benz: One of the main ones, Jason--and we talked about this--is that these correlations can move around a lot. So, a category that was sold as a must-own diversifier one year may not really deliver in the clutch. Commodities, as I mentioned, real estate investments--their diversification has kind of waxed and waned over the years. The one relationship that has held up through a variety of market environments has been the relationship between high-quality bonds and stocks of all stripes; we tend to see a good negative correlation there that will tend to reduce risk in investors' portfolios. It seems to me that there are good intuitive reasons why you could expect that relationship to hold up--that U.S. bonds, that high-quality bonds may, in fact, go up at a time when the equity portion of your portfolio is going down. So, I think that you can safely still hang on to that idea of stocks and bonds having good diversifying influences upon one another.

Stipp: Very interesting correlation data and some helpful tips on how to use it. Thanks for joining me, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.