BERKELEY, Calif. - As giant pension funds pour billions of dollars into international equity markets, two investment consultants with BARRA Inc. have said the optimal allocation to foreign equities is at an historically low level and the payoff for investors diversifying internationally "in the form of lower volatility" is very small relative to the historic norm.
As the allocation of large pension funds to foreign equity has increased to about 11%, the consultants found that the optimal allocation of assets to foreign equities has fallen to 20%, down sharply from about 60% in the late 1980s.
In their 20-page study about to be released publicly, Christopher Luck, consultant and director of sponsor services, and Ranjita Choudhury, consultant, found an international allocation paid off for investors in the 1980s, but in the 1990s it has had little effect in reducing volatility, and delivered comparatively lower returns.
While the study found international equity investment has had little effect in reducing volatility, large pension funds have been disgorging money into foreign markets. A Pensions & Investments survey found some plans doubled and tripled their international stock allocation in 1994, and the top 200 defined benefit plans increased their foreign equity allocation nearly 33%. The survey also showed the largest 200 pension funds, those fund reporting foreign equity investments had about 11% of their assets invested in foreign equities.
Typically, U.S. pension funds have been underinvested in foreign equity markets relative to optimal portfolios. However, the BARRA study found this underinvestment is "less glaring" now compared to the 1980s because of the decreased attractiveness of international markets in providing risk reduction.
"The underinvestment has also had less of an effect, as the risk reduction 'pickup' to international investing has recently grown much smaller," the consultants said.
From an investment standpoint, they said, staying at home during the 1990s, "may have even proved to be the wiser decision."
They said that optimal international diversified portfolios, hedged or unhedged, have had mixed results in reducing risk relative to the S&P 500 itself.
Two factors, they said, have made international equity markets less attractive from the standpoint of diversification. The most important factor, they said, is the significantly reduced volatility of the U.S. market combined with the increased volatility of foreign markets.
Between the October 1987 crash and June 1994, the BARRA study identified the annualized standard deviation of the S&P 500 at 12.92%, the unhedged annualized standard deviation of the Morgan Stanley Capital International Europe Australasia Far East Index unhedged index at 19.11% and the annualized standard deviation of the EAFE hedged index at 16.47%.
For the same period, the International Finance Corp. Emerging Market Index had an annualized standard deviation of 22.57%.
The second reason international equity markets are less attractive, they said, is the increase in correlation of international markets with the U.S. market.
The correlation between the U.S. and the developed international markets has remained "surprisingly stable," the study found. From 1981 to 1994, the S&P 500 and the hedged EAFE markets have a correlation of 0.5638. The study found the October 1987 crash dramatically increased the correlations between the hedged EAFE and the S&P 500 to 0.5335 from 0.4703 when the crash investment return is excluded. When examining pre-1987 vs. post-'87, there has been only a very slight increase in correlation between the U.S. market and EAFE developed markets.
It's unlikely, the consultants said, that dramatic shifts in correlation among foreign and U.S. markets will occur. They said contrary to popular opinion, "the correlation of the U.S. and EAFE markets has been remarkably stable since the inception of EAFE."
The BARRA consultants sought the optimal portfolio by combining U.S. and international indexes that offered the lowest volatility based on actual historical relationships. They said the lowest volatility combination for U.S. investors depends on the volatility of the underlying indexes and the correlation of indexes.
During the early 1980s, the "minimum risk 'optimal' combination called for an approximately 40% international allocation, increasing to about 60% during the latter part of the 1980s." During that period, they said, the optimal allocation preferred developed over emerging markets.
However, during the past five years "a combined portfolio of three established market indexes (the S&P 500, the EAFE and the IFC Global Emerging Markets Index) with an international allocation of only 20% has offered the most attractive diversification potential, with the allocation now slanted toward the emerging markets."
They noted the emerging international markets are a "much more attractive vehicle for diversification than the developed markets" now. The study found the combination of the S&P 500 and EAFE index showed lower volatility than the combination of the S&P 500 and IFC index until the two most recent five-year periods. The study said the volatility of EAFE has remained high, but has dropped for the IFC.
A small group of sophisticated and large pension funds do have foreign equity allocations of 20% or slightly higher. The defined benefit funds with 20% or more as of last September, according to the P&I survey, include Atlantic Richfield, 25%; Travelers, 23.6%; Owens-Illinois, 23.5%; Pacific Gas & Electric, 23.5%; Pacific Telesis Group, 22.9%; United Technologies, 22.5%; U S WEST, 22%; IBM, 20.7%; and Federal Express, 20.3%.
Gunter Ecklebe, client executive of the pension consulting firm Frank Russell Co., Tacoma, Wash., said the optimal allocation to foreign equities of any specific plan would depend on the plan's "risk tolerance," but generally speaking the optimal allocation now might be 25% of total assets in foreign equities.
He said his recommendation about the strategic optimal mix isn't based on short periods of U.S. and international market correlations, but would be based on a 15-year period.
He said the international and U.S. market correlations tend to go "up and down" over shorter periods.
"The correlations between the emerging markets and the U.S. equity market have gone up even though they are still on a low level. At the same time the correlations between the emerging markets and the EAFE markets have gone down on a rolling 10-year basis.
"One went up and the other went down. We don't want to change our strategic outlook based on these kinds of changes," said Mr. Ecklebe.
