How to Best Diversify from the S&P 500 Index

Data over the last 10 years calls into question whether currency risk really provides meaningful benefits—as it unquestionably has increased the risk profile of global portfolios. The analysis below starts with the S&P 500 and blends 10% increments of a portfolio to either:

• The MSCI ACWI ex-US Index in U.S. dollars — which has foreign currency risk

 

• The MSCI ACWI ex-US Index in local currency—which has no foreign currency risk

 

• Evenly between the MSCI ACWI ex-US Index in U.S. dollars and in local currency

If currency did in fact add diversification over the period, then the blends that added incremental weight to the MSCI ACWI ex-US Index in U.S. dollars should show the best risk/return trade-offs.

Blending MSCI ACWI ex-US to S&P 500- Last 10 Years
04/30/2005 – 04/30/2015

SP-MSCI-ACWI-Returns
Lower Risk than the S&P 500 Index: Over the 10-year period shown, the S&P 500 Index had average annual volatility of about 17.4%. The MSCI ACWI ex-US Index (in U.S. dollars) had a 16.4% average annual volatility over the same period. Taking away the currency risk brought the average annual volatility down to 13.5%—almost 4% lower than that of the S&P 500 Index.

Importance of the 50/50 Mix: We recognize that currencies tend to move in waves and that this 10-year period might be one in which foreign currency exposures faced a particular headwind. Therefore, an interesting baseline could involve looking at mixes of the MSCI ACWI ex-US Index that were 50% in local terms (i.e., without currency) and 50% in U.S. dollar terms (i.e., with currency). This would minimize the risk of being fully exposed or unexposed to fluctuating exchange rates, given that there is no way to know precisely how they might behave in the future.

• Notably a 50/50 blend of the S&P 500 and foreign equities reduced the volatility of equities from over 17.38% for the S&P 500 to just 14.22%.
• Risk can be reduced even further if one concentrated on just the local equities without the currency risk. The 50/50 blend of S&P 500 and MSCI ACWI ex-US Index (in local currency) had a volatility of 13.73%.

If the last 10 years are any guide, the real diversification of international exposures comes not from holding currency on top of equities but rather from just the equities themselves. With many investors questioning the valuations in U.S. equity markets, now is a very natural time to be looking at foreign allocations that are priced at lower valuation multiples than the U.S. markets.

But a big question is whether one should take foreign currency risk when going overseas. Many feel the dollar has strengthened already and they missed the opportunity to hedge their currency risk. But this long-term analysis shows why hedging can be an important part of strategic allocations to foreign markets to achieve a lower risk profile for global portfolios.