When advisers talk about diversification, their go-to variable is correlation. Finding an asset with low correlation with equities and bonds is a key consideration of every asset allocator and chief investment officer (CIO) of an institution. But correlation is not everything.
What really matters for diversification is dispersion.
A big concern of my friends who advise US clients these days is that their clients are losing faith in international diversification. After more than a decade of outperformance by US stocks, US investors are wondering why they should even bother with European or emerging market equities. European investors, on the other hand, are tempted to shift more and more of their equity allocation toward the United States. After all, the US market seems to be the only one doing well.
So when advisers or consultants show up and tell investors that international diversification is beneficial in the long run, they either quote John Maynard Keynes or suggest that the correlation between US stocks and those of other developed markets is so high that there is little benefit to diversifying.
As an example, over the last 100 years, the correlation between US and UK stocks was a whopping 0.7 — not perfectly aligned but close enough to warrant an arbitrage position from an arb hedge fund. Not much diversification benefit to harvest from UK stocks if you are a US investor, is there?
The chart below shows the difference in rolling 10-year total returns for US and UK stocks since 1920. Whenever the line is above zero, US stocks outperformed their UK counterparts over the past 10 years. When the line is below the zero, the opposite occurred.
US vs. UK Stocks: Annual 10-Year Total Return Differentials
Source: Fidante Capital
While the average performance difference between the two markets over the last 100 years is zero, the 10-year return differentials can be extremely large. From June 1942 to June 1952, for example, US equities eclipsed UK stocks by 11% per year. For 10 years! That adds up to 185% outperformance over a decade. This was clearly driven by the destruction World War II inflicted on Europe and the United Kingdom and the stimulative impact it had on the United States. But even if we ignore World War II, there are 10-year periods when US equities well outpaced those of the United Kingdom. The 5.6% outperformance the US market enjoyed in the last 10 years is hardly exceptional.
On the other hand, there are plenty of intervals when UK equities outperformed by a wide margin. During the high-inflation era from 1975 to 1985, the UK market beat the US market by 17% per year (!) thanks to its tilt toward energy and mining companies.
This range of outcomes is what we think of when we talk about dispersion. While there is no difference in the two markets’ average performance, the one standard deviation return difference between them is 4.4% per year — or 54% after 10 years.
That’s why the focus on correlation over dispersion is shortsighted. It ignores the material diversification benefits that can be achieved with assets that seem to move in tandem even though the steepness of the trend might vary considerably, giving rise to significant performance differences.
Dispersion is also forgotten by those who dismiss return forecasts anticipating wide variations between US and non-US equities in the future. Their typical argument is that the United States dominates global equity markets, so if the US stock market has low returns, then European and emerging markets cannot have high returns. The comparison between US and UK equities over the last century shows how faulty this logic is and why we can reasonably expect big return differentials between US and European or emerging market stocks in the years ahead.
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer
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