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.