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Swedroe: World Isn't Flat—Invest Accordingly

posted on Friday, August 25, 2017 in What We're Reading

image of a flat globeEver since the financial crisis, when the correlation of all risky assets rose toward 1, investors have been hearing that the world has become flat and the benefits of international diversification are gone. The explanation generally is that the world market has become more integrated and financial markets more globalized.

The Power Of Mononationals
Cormac Mullen and Jenny Berrill contribute to the literature addressing the merits of international diversification with the study “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” which appeared in the second-quarter 2017 issue of Financial Analysts Journal.

Mullen and Berrill showed that one way to recover international diversification benefits is to decrease the internationalization in investors’ portfolios by lowering exposure to the stocks of foreign multinationals and focusing on what they called mononationals.

The authors concluded: “Despite the decrease in international diversification benefits documented in recent papers—and a research focus in recent years on the benefits of stocks from emerging and frontier markets—we found there is still international diversification potential in developed-market equities. We suggest that a portfolio of international stocks classified solely as domestic offers the potential for more international diversification benefits than a portfolio of more-internationalized stocks.”

While their conclusion does have the benefit of being intuitive, there’s really nothing new here. Multinationals are more likely to be large companies, and mononationals are more likely to be smaller companies. Additionally, it has long been known that the benefits of international diversification are greatest when investing in smaller companies.

For example, Rex Sinquefield’s study, “Where Are the Gains from International Diversification?”, which appeared in the January/February 1994 issue of Financial Analysts Journal, showed that international small stocks diversified U.S. portfolios more than the large stocks of the EAFE Index.

While foreign large companies do have exposure to their domestic economies, their earnings are more likely to be impacted by global conditions than the earnings of smaller companies, which tend to be more dependent on the conditions of local economies. Thus, their returns are driven more by local, idiosyncratic factors. This makes them a more effective diversifier than international large stocks.

As an example, the performance of two giant, global pharmaceutical companies (like Merck and Hoffmann-La Roche) is likely to be more highly correlated, because their products are sold around the globe, than the performance of two small-cap domestic restaurant chains whose products are sold only in their home countries.

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The content of this article was written by a third party, not an employee of Northwest Wealth Management.

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