Buy international stocks, but watch correlations

Improved international equity returns have U.S. pension plan executives looking at increasing their offshore investing, but officials at Vanguard Group Inc. are warning those executives that they need to pay attention, or they could get less diversification than they thought.

But allocating some portion of assets to international equities reduces portfolio volatility, as long as the long-term correlation between developed economies is less than perfect, said Yesim Tokat, Vanguard investment analyst and author of a new report, "International Equity Investing: Long-Term Expectations and Short Term Departures." The paper is the first in a series addressing international investing by U.S. institutions.

Investors need to consider several points: how closely correlated international developed economies and U.S. stocks have become, in that market returns and volatility are very similar for United States stocks and those of other developed countries; whether international economies will provide better returns than the U.S. market; and if they will reduce overall portfolio risk over the long term, Ms. Tokat said.

The correlation among developed markets currently stands at 51%, said Ms. Tokat. Using mean variance analysis, this level of correlation would imply that investors should allocate 30% of their equity portfolios to international stocks. But if correlations increased, the optimal international equity allocation would fall as the diversification benefit decreased. If the correlation between developed markets increased to 70%, the recommended international equity allocation would fall to 20%.

"Correlations may be somewhat higher over the next 20-30 years if economic and financial integration continues," said Ms. Tokat.

U.S. pension plans using a market capitalization approach for determining their international equity allocations might invest 57% of equities in international stocks, based on country weightings in the Morgan Stanley Capital International World ex-U.S. index, she said.

Recent data from Greenwich Associates, Greenwich, Conn., show that, on average, corporate pension plans and endowments have 25% of their equity portfolios allocated to international equity.

Yet Catherine Gordon, head of investment counseling and research for Valley Forge, Pa.-based Vanguard, recommends that institutions invest only 20% of their equity portfolios internationally because of increasing long-term correlation between developed economies.

"But correlations are still low enough to warrant an international allocation to get the diversification benefit," she added.

Ms. Tokat said U.S. pension plans have some compelling reasons for wanting to keep their money at home. Transaction costs, including local brokerage, and cross-border money transfers; local capital gains or taxes in countries where institutions are not tax-exempt; and restricted market access can eat away at returns to the point where international investments becomes less attractive.

In addition, pension plans might not want to wait out the short-term losses to get to the long-term benefits. Over short periods of time, international investing can look expensive and complicated with little benefit, but over the long term, it pays off through either diversification or increased investment returns. "Most institutions have a long-term view, but the nature of the evaluation process calls performance into question over relatively short-term periods," said Ms. Gordon.

There is often a lot of "noise" and distraction in short-term market trends, she said. For example, despite short-term currency, inflation-adjusted exchange rates among developed country currencies have remained constant over the long term.

Since 1975, an allocation to Australian, European and Far Eastern equities has helped reduce portfolio volatility over rolling three-year periods, Ms. Tokat said. For periods of more than 10 years, diversification is the main benefit of international investing, but this benefit is not apparent over two- to three-year periods, added Ms. Tokat.

Her research also showed that the benefits of international investing vary, depending on the performance of the U.S. market.

During past six out of eight U.S. bear markets between 1973 and 2003, a 20% allocation to stocks in Australia, Europe and the Far East provided a 2.3% greater return and 0.59% lower volatility, on average, than a portfolio of just U.S. stocks. But during U.S. bull markets between 1973 and 2003, a 20% international equity allocation provided a 1.12% lower return and 1.18% lower volatility, on average.