Small companies may be best bet in seeking diversification abroad

Dollars & Sense

April 22, 2001|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

For most of the past several decades, a portfolio with a mix of foreign and U.S. assets has shown better risk/reward characteristics than an all-U.S. portfolio.

Recently, however, studies have shown that the benefits of international diversification may be decreasing. The most recent of these comes from a couple of economists at the International Monetary Fund. It shows that industry-specific factors have recently done a better job of explaining global stock market returns than have country-specific factors.

In other words, companies' home countries are starting to matter less than their industries, which suggests that the diversification-by-region idea may no longer hold.

The folks at the IMF also point to the increased weight of technology shares in the world's markets. Although you can write this off as just a side effect of the global tech bubble, I don't think that tells the whole story.

Most technology companies deal in tradable products that are easily exported and imported. So it makes sense that their corporate fates would be more closely tied to global-industry issues than country-specific problems.

This brings up an interesting idea: The diversification issue isn't simply a clear-cut choice between spreading risk across industries or spreading it across countries, but involves differentiating between "tradable" and "nontradable" industries.

For tradable industries (technology, capital goods, etc.) it's going to be tough to achieve any meaningful diversification because the global returns across these industries are likely to be similar. For nontradable industries (services, mostly), the story is quite different in that company returns are likely to be affected more by local factors than global ones.

So, to achieve maximum diversification in theory, you would want to separate your portfolio into tradable and nontradable industries, and only worry about international diversification in the nontradable portion. In practice, this would be fairly difficult, partially because of the limited availability of investment vehicles for doing this kind of finely tuned portfolio tweaking, and partially because some industries aren't clearly tradable or nontradable.

Practically speaking, it seems as if the best way to achieve international diversification might be to focus on smaller foreign companies, whose fortunes are guided more by local factors than global ones. In any case, it may be that the results reported in the IMF paper are simply an artifact of the late-1990s tech bubble. I wouldn't bet on it, though, since the trend toward more integrated global capital markets seems unlikely to reverse anytime soon.

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