Is international diversification passé?

    The benefits of international portfolio diversification, especially in equities, became well-established in financial theory and practice in the early 1970s. The benefits are the decrease of portfolio risk or volatility, measured by standard deviation of rate of return, coupled with the potential increase in expected rate of return. These benefits will obtain even if foreign assets are riskier than domestic assets, including the currency risk, as long as the positive correlation between the domestic and foreign markets is imperfect, i.e., less than one. The lower the correlation the larger is the total risk reduction. Although correlations between US and non-US equity markets have trended upward since 1970, indicative of higher correlations among other countries, they are still much lower than unity (see the chart below). The imperfect correlation is due to differences in national and regional economic, political and social structures, fiscal and monetary policies, government regulation of the economy, cultures, etc. International diversification can also increase the potential expected total rate of return if foreign markets have higher rates of return (measured in domestic currencies), primarily due to higher real economic growth rates or appreciating currencies (assuming no hedging). For example, during 1986-2005, among the 10 major global equity markets, a non-US market yielded the highest annual average return in every single year.

    The major benefit of international diversification, just like domestic diversification across equities and bonds, however, is total portfolio risk decrease, much more certain than total rate of return increase. It is, in fact, the rare free lunch. During the last decade, it has become more popular, especially through investments by developed countries in emerging markets, despite the still considerable barriers to such investments. Recent research has confirmed the long-term benefits of diversification, during the last three decades, across international equities in terms of its promise of reduced risk and even risk-adjusted higher returns (the Sharpe ratio).The benefits of international diversification would be much greater for a Turkish investor than for a US investor since Turkish equities account for a much smaller share of the global market capitalization. Besides very few Turkish companies come close to being large multinationals with operations across the globe that offer the benefits of indirect international diversification.

    In recent years, correlations among both developed and emerging markets have increased, as noted earlier, especially during brief periods of extraordinarily high market volatility. But we have to distinguish the long-term slow and the short-term sudden increases in correlations from each other. The long-term ones result from globalization driven by deregulation, privatization, and liberalization of international trade and investment. Market movements have become more synchronized, reflecting partly greater synchronization of business cycles, another outcome of globalization. The short-term sudden and temporary increases in correlations, referred to as “correlation breakdowns,” may result from deviations from normality assumptions during crises when markets crash all at once or one after another. Recent research has also indicated that the apparent observation of short-term correlation increases can be statistically explained by greater market volatility, with no increases in actual correlations themselves.