Editor's note: We're kicking off International Week here at IndexFunds.com. First up, we've reprinted this classic Jim Wiandt article from way back in the summer of 2000. Some of the data is of course a little dated, but the article is still informative and raises interesting and relevant issues. Mr. Wiandt is the managing editor of The Journal of Indexes. Later this week we'll post more articles on international equities, including a chat with MSCI regarding its updated global style index methodology, and a sit-down with international guru Steven Schoenfeld of Barclays Global Investors.

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So you've got a house, a broad section of the U.S. stock market, and some bonds. You think you're diversified? Think again. Without a healthy allotment of international stocks, your portfolio is not as diversified as it can be.

Many investors and financial advisors advocate minimal exposure abroad, claiming that U.S. multinationals provide adequate diversification abroad. Still others say that the United States and foreign markets historically have very high levels of correlation, particularly during bear markets, when you need the benefits of diversification most. I will go through these issues (and many more) point by point, bringing each of these false claims to its knees.

International Equity Assets in 1999

Most Americans are shamefully underinvested abroad. According to the Investment Company Institute, at the end of 1999 there was a total of $6.85 trillion invested in U.S.-based mutual funds. Of that total, only $585 billion was invested in international funds. (Ed note: According to the ICI, at the end of 2001 nearly $4.3 billion was held in world equity funds - emerging markets, global, international, regional - out of $4.7 trillion total invested in equity funds.) This amounts to 8.5% of the mutual fund total. And this, despite the fact that according to Morgan Stanley Capital International, foreign stocks account for some 51% of global capitalization.

Furthermore, the problem seems to be getting worse, not better. The most recent statistics also indicate that new cash flow has been going disproportionately into U.S. funds. This is owing largely, of course, to the higher returns of the U.S. market . . . more money chasing higher returns. In 1998 and 1999, only 5-6% of new mutual fund money was going into international funds.

Why Invest Abroad?

Okay, you say, so Americans don't invest abroad. I don't need to look any further than my own portfolio to know that. Give me one good reason to put my money in risky global markets. I'll give you several.

1) Foreign markets do not move in lockstep with U.S. markets. Oftentimes, when United States markets fall, international markets rise, and vice versa. A simple examination of returns over the past ten years shows that while international and US markets do sometimes move in tandem, their performances often move counter to each other. The net effect, of course, resulting from any divergence of returns is increased portfolio diversification.

As a sidenote, I would add that many global indexes (such as the EAFE, an index containing representation across the developed markets of Europe and Asia) are weighted heavily toward large-cap stocks. Often these stocks, like U..S multinationals, are more likely to move in step with the domestic economy. While there are diversification benefits in buying large foreign equities, the cross-correlation and diversification benefits rise exponentially with small foreign stocks that are more tied to local economies.

Walter Updegrave of Money magazine examined recent correlation levels of U..S and international stocks. (If two assets are perfectly correlated, they have a correlation of 1.0, if they are in synch but in opposite directions, correlation is -1.0. If their returns are unrelated, the correlation is 0.) Updegrave found that over the past five years, most large cap-biased foreign funds had a correlation with the S&P 500 of .70 or higher (compared to 0.59 for the U.S. small cap Russell 2000). However, correlation of foreign small-cap funds were lowest of all.

2) Your portfolio should act as a diversifier to your complete financial profile. Your salary and the value of your assets are dependent on the state of the U.S. economy. In the same way you should buy bonds to hedge against a catastrophic collapse of the U.S. economy and subsequent loss of your job, decline in property value, etc., you should also diversify internationally as a hedge against your huge bet with the U.S. economy.

3) U.S. multinationals do not provide adequate exposure to foreign markets. For a number of reasons, U.S. multinationals, despite deriving a significant percentage of their revenues abroad, do not provide adequate foreign exposure. Most of their costs (particularly labor) are from the U.S., as is the majority of the capital they raise. In addition, most of these companies are primarily held by U.S. investors in U.S. markets, and tend to act in concert with the domestic market (and therefore the domestic U.S. economy).

4) International markets can provide some cover for U.S. investors during a downturn in the U.S. economy. I list 1977, 1984, and 1987 as examples of years when the U.S. market was bearish, while foreign markets were bullish, providing ballast for diversified U.S. investors. Even if U.S. and foreign markets moved largely in step, with a correlation of, say 0.75, this still provides diversification benefit.

5) Foreign markets are becoming more hospitable to investors. In Europe and Asia, in particular, financial and tax systems are becoming increasingly standardized and transparent. In addition, the vast new influx of European pension investors bodes well for the European equities markets. While (tsk tsk) it is a timing argument, European markets are on the front end of the pension boom that has largely run its course in the United States.

5) Japan 1989. This is all I need to know to be certain that I should be fully diversified internationally. There is always the possibility that the U.S. economy will fall into a brutal, prolonged bear market that is not shared by the rest of the global stock market. Call it reversion to the mean. Japan's economy was declared infallible in the 1980s, and its stock market rose to stratospheric levels not unlike those the U.S. economy is enjoying today. When the party was over, though, it was really over. While the Wilshire 5000 index of the total U.S. market has enjoyed annualized returns of 17.27% over the past 10 years, and a blistering 22.45% over the past five, the Japanese market has run up an abysmal 0.07% over the past 10 years, and lost 1.35% annualized in the last 5.

6) This is the clincher. The evidence seems to indicate that internationally diversified portfolios just flat outperform portfolios containing only U.S. equities. Furthermore, these higher returns have come without extra risk (measured for our purposes by standard deviation).

To illustrate my point, I have dipped into the resources of team DFA (Dimensional Fund Advisors), using data and charts provided by Mark Hebner of Index Funds Advisors. The first chart allows you to see the composition of the DFA model portfolios to understand what is being compared.

The second chart is the most instructive. It shows a comparison of returns of different DFA portfolios compared with the booming S&P 500 index, on which about 100 mutual funds are based, and which has in recent years enjoyed returns considerably higher than those of the total US market.

This, of course, amounts to considerably more capital gain, and with slightly less risk (standard deviation) than was found in the S&P 500 over the same time period.

Conclusion

The conclusion could not be more simple. Diversify your portfolio globally. It will provide your financial profile with not only increased stability, but very possibly higher yields with less risk.