Global diversification still works, but only for the patient: James Saft

(Reuters) - The market is still offering globally diversified equity investors a free lunch, but only if they are in it for the long haul.

That’s good news given the drubbing diversified investors took during the great financial crisis due to a rise in correlation of stock and bond markets. If everything goes down and up at the same time and in the same way, diversification would lose its value.

Since Nobel Prize winner Harry Markowitz first coined the phrase in 1952, diversification, with its ability to enhance portfolio returns while suppressing volatility, has been widely acknowledged as the ‘only free lunch’ in investing.

The conventional argument for international diversification held that the investor’s prospective holding horizon made no difference. What did matter was the volatility of the markets involved, their expected returns and how closely correlated they were to one another. Since markets trade differently to one another, spreading one’s bets reduces volatility overall, reducing risk and, generally, allowing investors to take a more aggressive allocation in consequence.

A new study from researchers at Harvard University finds that for equity investors with long-term holding periods, international diversification still works.

“If anything, the benefits of holding global equity portfolios for long-horizon investors have increased since the turn of the century. Long-term investors can still use global portfolios to diversify away long-term equity cash flow risk,” Luis Viceira, Zixuan Wang and John Zhou of Harvard write in a new working paper. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2941652)

On one argument, as global markets have become more inter-connected due to investors being active in many of them, they have become more correlated. An investor who loses money in U.S. stocks, for example, and needs to raise cash will now sell a bit of her global stock portfolio, spreading the impact of a downdraft.

Correlations during the peak of the crisis were more than double their levels during much of the 1990s, and even now remain elevated.

Much depends, the study finds, on the kind of news that drives a shock to global markets. If it is fundamental news which implies business conditions will be worse, correlation increases will hit all investors regardless of how long they intend to hold their stocks or bonds, according to the study. So the kind of event which might make for worse corporate cash flow across international economies will genuinely reduce the value of being diversified.

TWO KINDS OF GLOBALIZATION

Changes in discount rate news, the market interest rates investors use to value future streams of earnings, behave differently, in large part because the discount rates tend to revert to previous means. That means that if you are a long-term investor and can sit out a global downturn your benefit from diversification will hold even though you suffer in the short term from a rising correlation.

In other words, higher correlation due to globalization of markets doesn’t hurt the value of diversification but higher correlation due to globalization of economies does. Equity correlations have been driven more by financial market integration than economic integration, meaning the value of international equity diversification still holds for long-term investors.

The study looked at stock and bond markets in seven large developed countries between 1986 and 2013.

“When discount rate shocks become more correlated across markets but cash flow shocks don't, long-horizon investors can still use global diversification to attenuate long-run cash-flow risk, which is the most relevant risk to them,” the authors write.

The notable decline in equity market volatility within countries has if anything increased the benefits of holding stocks, at least if we expect that decline to persist.

For bond investors, however, it is a different story. Bond market correlation is more driven by economic integration than financial market integration, meaning that the diversification free lunch for bonds has genuinely diminished. A diversified portfolio of bonds is still valuable for insurance companies and pension funds who want to hedge their long-term obligations, however. That may imply that demand for bonds from the huge number of pension funds and others with long-term obligations may be driving bond prices beyond their true underlying economic value, though this was not the subject of the study.

Free lunches are rare in life, and rarer still in investing. We who can be patient with our equity portfolios should take advantage and diversify internationally.

(Editing by James Dalgleish)