Note: This article is part of ETF Trends Strategist Channel.
By Dr. Vito Sciaraffia
Diversification correctly has been deemed “the only free lunch in investing.” However, the typical U.S. investor has failed to make a full meal of it. In this piece, we examine how international portfolios can benefit by fuller and more thoughtful diversification.
An initial step for proper diversification is achieving exposure to as wide a breadth of the markets readily and efficiently available for a given type of asset class. For example, two-fifths of the market capitalization of global equity markets is in countries outside of the United States. Hence, U.S. investors’ portfolios can benefit from the expanded set of fundamental exposures—developmental, macroeconomic, demographic and political characteristics, among many others—those international markets represent.
However, we believe that even more benefit can be found by diversifying within those passive international equity exposures, an approach we refer to as enhanced weighting. And good news for U.S. investors is the evolution of exchange traded funds, which has greatly expanded the available universe of country-specific equity markets. As a result, augmenting portfolio diversification through both expanded representation and enhance weighting of equity markets (i.e., countries) is much easier to achieve in modern portfolios than it was just a few years ago.
Rethinking representation and weighting
Nonetheless, achieving enhanced representation is only part of the solution. Generic passive capitalization-weighted regional allocations miss the mark when it comes to the second step in improving portfolio diversification. A key driver of that thinking is the fact that most passive indexes are market capitalization-weighted, with no “cap” on the percentage representation of individual country equity markets in the index. So, while investment strategies that seek to track that index might be great ways to diversify a purely domestic U.S. exposure, the index can be seen as allowing the undue influence of a few countries to overshadow the broader merits of the many.
The MSCI All Country World ex. USA (ACWX) Index, for example, is a commonly used benchmark by U.S. investors to measure the performance of international markets. According to MSCI, the index represents 22 developed market countries and 23 emerging market countries, and covers approximately 85% of the global equity opportunity set outside of the United States. At a glance, the index seems reasonably diversified, at least in terms of representation.
As shown in Figure 1, the top five country equity weights are close to 50%. The top ten countries represent nearly three-quarters of the index, leaving the remaining 35 competing for a mere quarter of the index weight. Unfortunately, that doesn’t quite sound like good diversification.
Room to Improve
Incremental diversification atop passive, capitalization-weighted exposures can provide additional risk-adjusted return over that static market-weight allocation. The goal is to develop appropriate methods that survive the test of time. International equity index exposures provide easy targets, as the most well-known are heavily exposed to a slim number of country equity markets.
We developed an equal-country-weight version of the MSCI ACWX to demonstrate the potential benefit of improved diversification among allocations at the country-equity-market level in international markets. In Figure 2 we show the long-term returns of both the market-cap-weight and the equal-country-weight indexes. Obvious at the outset is the long-term outperformance of the more diversified (same representation/membership, but more diversified by weight/allocation) equal-country-weight index reconstruction, versus the capitalization-weighted version.
We also see in Figure 3, that the regional composition of long-term contribution to index total return shifts to those regions that held weaker weights in the cap-weighted index, but which saw on average higher total returns. That shift, in turn, pushes overall long-term total return higher for the equal-country-weighted index.