Despite the strong performance of U.S. stock and bond markets during the past few years, investor anxiety seems to be increasing. The past year's volatility in global markets has put nerves on edge, and one common complaint is that the promised diversification benefits of international equity investing have not materialized. Some investors have noted that during the recent forceful declines in the U.S. stock market, foreign equities have tended to move lower in a coordinated fashion, creating a domino effect on the total portfolio.
This has led many to conclude that foreign equity diversification doesn't seem to help a portfolio when it really needs it, i.e., when high volatility dominates the domestic market.
But a deeper look at historical price behavior indicates the logic and benefits of international investing still hold. In fact, contrary to the view of today's skeptics, the diversification benefit is even stronger during severe market downturns than in normal market conditions.
Why invest abroad?
By now, most institutional investors have heard the key reasons for investing internationally: it lowers risk while offering a chance at higher returns for the total portfolio.
This argument works as long as various equity markets are imperfectly correlated -- in other words, if gains overseas can offset negative domestic performance. Of course, if global markets move in unison, there would be no international diversification benefit.
Without international investing, diversification is only possible within the domestic equity market. But domestic diversification in the U.S. has never neutralized the overall market or systematic risk of the American economy. Foreign equity markets have provided an outlet to diversify away part of this risk. In addition, because most of these markets conduct trading while U.S. markets are closed, they react to news and world events during alternate times, offering a degree of independence in price behavior. These diversification benefits, however, come at a price. Currency conversion costs, custody fees and generally higher trading commissions and management fees accompany most foreign investments.
The correlation coefficient
The degree to which the U.S. and foreign equity markets move in relation to each other is measured by the correlation coefficient. This statistic measures the relationship between two sets of data and is bounded between -1 for inverse movement and 1 for symmetrical performance. If the argument for international diversification is founded on low correlations between domestic and foreign markets, then the correlation coefficient will be significantly below 1, but likely be above zero, because most markets have some level of correlation.
To see whether correlations between U.S. and foreign markets increase during periods of market volatility, we examined the price performance of the international developed large-capitalization universe (proxied by the Morgan Stanley Capital International Europe Australasia Far East index) during large negative moves in U.S. large-cap stocks (proxied by the Standard & Poor's 500 index). We used the average price movement (in percentage terms) of the S&P 500 on all days from the beginning of 1988 where there were precipitous declines (of two or more standard deviations), netting 68 observations.
The above table shows the daily price behavior of the EAFE vs. the S&P 500, as well as subsequent price returns of both indexes for the week, month and quarter that begin with these large, single-day price declines. Even though it may seem to investors that foreign markets move in tandem with the S&P 500 during extreme declines, the evidence since 1988 shows the relationship is less intense than some have thought. When the S&P 500 declined by two standard deviations, the average return of -2.35% coincided with an average of -0.66% in EAFE. The correlation between the two indexes was low (0.28), which suggests relatively minor linkage. Indeed, these data contradict the view that during periods of high domestic volatility, markets tend to move in lockstep.
For broader time frames following these large S&P 500 price declines, market movement remained uncoupled. Although still substantially uncorrelated, the weekly, monthly and quarterly correlations actually were higher during the periods following the volatility than during the volatility.
Correlations in up markets
During the largest positive S&P 500 price moves (using the same methodology as above and yielding 63 data points), EAFE went up as well, but about one-third as much as the S&P 500, as shown in the table.
The resulting correlation was higher than in the declining price data. During the following week, month and quarter, the two indexes ventured higher, with the EAFE return generally about one-half that of the S&P 500. Correlation coefficients were steady (0.32 to 0.51) across all observed time frames. Again, like the analysis during market declines, the S&P 500 and EAFE correlation was not stronger for the high volatility events compared to longer-term observations.
How does the relationship during periods of high volatility compare with normal market conditions? The daily correlation coefficient from January 1988 through June 1998 was 0.30, while the weekly, monthly and quarterly observations were 0.41, 0.45 and 0.45, respectively. These numbers show the daily correlation during sharp declines actually was less than during normal market conditions; the relationship during volatile up moves was about the same as general market periods. Such findings might surprise investors who have come to believe there is a more predictable pattern to domestic and international equity price movement during volatile market periods.
Transcendent global events
Why do investors experience variations in the level of correlation over brief trading periods? The obvious answer is that certain global events transcend the local impact on economies, currencies and stock markets. In some periods, all markets are affected by the same factor. The Iraqi invasion of Kuwait and the collapse of some emerging Asian economies held the same ramifications for most developed countries. In addition, since cross-border investing has become more common, "panic" market movement tends to "follow the sun" after a local market has closed. In most periods, however, markets tend to move relatively independently.
Given the rapid changes taking place globally, is it prudent to assume the low correlations between U.S. and foreign markets will persist? As impediments to international investing continue to be reduced, and central banks increasingly coordinate economic policies, many believe correlation coefficients cannot help but be affected. In fact, when we looked at the daily correlation coefficients for the past 10 years, we found evidence of a slight increase. However, the increase is not significant enough to negate the very real diversification benefits offered by international investing.
While many investors today perceive that domestic and international markets move in tandem during periods of high volatility, the evidence shows correlations actually decline during these periods, which confirms that international investing still offers powerful diversification benefits for institutional investors.
Matthew H. Scanlan is a principal, and Kurt Livermore an associate, at Barclays Global Investors, San Francisco.
