AgPa #58: International Diversification – Doing the Right Thing is Hard Sometimes

International Diversification — Still Not Crazy after All These Years (2023)
Cliff Asness, Antti Ilmanen, Dan Villalon
The Journal of Portfolio Management 49(6), 9-18, URL/AQR

In the last post (AgPa #57), we have already seen that international diversification is a powerful protection against the higher-than-expected risk of losing real wealth with stocks over the long term. By coincide, three of the OGs from AQR Capital Management also just released an article about the Fors and Againsts of international diversification. Unsurprisingly, I picked that one for this week’s AGNOSTIC Paper1Regular readers of this blog may have recognized that I am a fan of AQR’s research. I stand by it…

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

If we take the theoretical idea of diversification, the actions for our portfolios should be very clear. Diversify via every dimension that is practically possible to achieve better risk-adjusted returns. With respect to equities, geography is obviously a very important one. Passive investors should hold a market-cap weighted portfolio of all stocks in the world. Active investors should execute whatever strategy they follow within the largest possible (global) opportunity set.

Unfortunately, this theoretical advice simply didn’t worked over the last 30+ years. The US stock market heavily outperformed most other regions and investors with non-US allocations looked very stupid.2Full disclosure: I am one of the stupid-looking folks… Obviously, people don’t want to look stupid and in particular not for more than 30 years. As a consequence, this week’s authors explain that many investors abandoned international diversification and now overweight the US in their portfolios.

To me, the whole US vs. International debate is very fascinating ever since I began investing around eight years ago. Some of the most iconic investors whom I studied (e.g. Warren Buffett, Ed Thorp, Jack Bogle) frequently recommended to just invest in a S&P 500 or US Total Market index fund and forget about the rest of the world. Even more puzzling, all three of them are big believers in passive investing. How can you believe in passive investing, but at the same time, run a permanent single-country-bet?3Given the large share of US equities in global benchmarks, a home bias is of course not as severe for US investors.

My explanation was (and still is) that they must see some permanent advantage for the US which I have not yet fully understood. I subscribe to some of the common arguments like that the US is a great place to do business, has a more entrepreneurial culture than many other countries, or that it has the most developed financial markets. Yet, I still believe that it is hardly possible for the US to outperform the rest of the world forever.

Without knowing that he is working on this week’s paper, I had the chance to speak with Cliff Asness about international diversification at an AQR event in Germany last October. I remember he said to me, “Doing the right thing is often hard and lonely”. Given that this is also a major theme of this week’s paper, I am very excited to go through the authors’ five major arguments for and against international diversification.

Important Results and Takeaways

For: Not everyone can invest in the best-performing market

When it comes to equity markets, the truly passive strategy is the market-cap weighted portfolio of all available stocks in the world. That’s what we have in aggregate and there is nothing we can change about it. By construction, some countries are going to be better than this weighted average and some are going to be worse. You can’t get a mean of five by averaging numbers larger than five.

Except you have the skill to always correctly predict the outperforming countries, this simply arithmetic suggests that some periods of underperformance are inevitable for any country. But for the sake of this argument, let’s assume that we collectively agree that the US is indeed the permanently best equity market. What will happen? Well, exactly what we observed to some extent over the last 30 years. More and more investors overweight the US market, prices go up, and it becomes a larger part of the global market portfolio. This leads to periods of strong outperformance, but all else equal, higher prices reduce the expected return going forward.

So even if the US has some permanent advantages over other countries, expected returns can be lower than for international stocks when it gets too expensive. In addition to that, the global market portfolio must clear. Just because everyone finds the US more attractive, the international stocks don’t disappear. Someone has to own them and for every US overweight, there must be an underweight somewhere else. So even if everyone believes the US is the best market, not everyone can own it.

Bottom line: Only investing in the US is an active bet on a single-country and implicitly assumes that the rest of the world will always underperform. This is absolutely possible but requires a correct forecast which is very difficult. If you have the skill to do that, you should start a hedge fund and don’t waste your time thinking about international diversification. If not, going for international diversification is the more rational choice.

Against: Everything crashes together

When things get really bad, correlations among equity markets (and other asset classes) tend to increase. In English: during periods of great stress, all markets usually crash together. Don’t expect a positive return from the German stock market when the US market loses 20% within a few days like in March 2020. At such time scales, international diversification was historically indeed not useful.

Over longer periods, however, this argument doesn’t work. For example, last week’s paper shows that the historical probability of losing real wealth from a 30-year investment in a single-country stock market is about 12%. International diversification drastically reduces this number to 4%. The authors of this week’s paper provide similar evidence and conclude that international diversification is a powerful protection against longer bear markets within individual countries. At least for long-term investors, they argue that this is much more important than protection against short-term crashes.

I think the best way to understand this argument is to simply reverse the perspective on the last decades. Suppose you were a European investor and made the (bad) decision to only invest in domestic equities. Without taking any active view on individual countries, you could have massively improved your outcome by simply going for international diversification. Of course, you would still have underperformed the big US winner. But with a global index, you were still much better off than just with Europe.

For: Historic returns don’t show changes in valuation

The authors’ next argument goes one step beneath just realized returns. If you think about common valuation ratios for stocks, there are two ways to explain returns. Fundamental performance and changes in the multiple. For example, suppose both the US and the non-US market trades at the same P/E ratio of 10. Let’s further assume that the multiple stays constant over time, but US companies achieve higher earnings growth. The same multiple applied to higher earnings leads to higher value and is a valid explanation for US outperformance.

Now, let’s look at the opposite. Suppose earnings growth for the US and non-US market is the same, but investors decide for whatever reason that the US is more attractive and are willing to pay a multiple of 12 instead of 10. Higher multiple applied to the same earnings also increases the value, but in this case it is not necessarily because of better fundamental outperformance.

In practice, both effects are of course active at the same time and the authors’ present the result of a regression framework to separate the two. The results are striking. Since 1990 the US, according to the authors, outperformed non-US developed markets by an incredible 4.6%-points per year. According to their estimates, however, about 3.4%-points of this comes from multiple expansion. The residual of 1.2%-points comes from fundamental outperformance and other factors but is not even statistically signifcant.

Now, it is of course easy to present such analyses after the fact and I doubt that many of the underperforming non-US investors find them useful. But that is not the point. The fact that most of the US outperformance simply comes from higher multiples could tell us something about the prospects going forward. The authors argue that another 30-year multiple expansion like this seems very difficult to repeat. I generally agree with them that multiple expansion is a less sustainable source of outperformance, but every investor must decide for herself if those results are enough for a long-term bet against the US market…

For: Valuation levels should eventually matter

Related to the previous argument, the authors next examine another important aspect of valuations. Although 30 years of US getting fundamentally more expensive is a damn long period, there is a lot of historical evidence that valuations tend to mean-revert. Of course, this is the idea behind the Value factor which historically also worked among equity indices.4See for example Asness et al. (2013).

Despite a painful 2022, the fundamental valuation of the US stock market appears still quite ambitious. The Cyclically Adjusted P/E (CAPE) ratio for the S&P 500 Index currently stands at about 30. That is a high absolute level, high with respect to the US market’s own history, and high compared to other stock markets around the world. Historically, high starting valuations usually came with lower long-term returns. Disclaimer: nothing is certain in markets and for the last decades, valuation-disciplined investors looked stupid. But common sense should suggest that, all else equal, something that becomes more expensive becomes less attractive as an investment.

For: International diversification provides opportunities for active investors

Finally, the authors review international diversification from the perspective of active investors. So far, most of the discussion was something like US index fund vs. Global index fund. But how does it look for investors who pursue active strategies? Well, an AQR paper obviously comes with a bias towards systematic and factor strategies but the results are very interesting.

To illustrate the idea, the authors show that the correlation of the Value, Momentum, and Quality factors across countries are fairly low (correlation coefficients between 0.25 and 0.40). For the non-nerdy people among us: A failure of Value in the US doesn’t necessarily mean it also fails in Europe at the same time. Implementing the same factor strategy in various markets and combining them to a portfolio can thus unlock massive benefits. Therefore, international diversification is fully in-line with the old maxim of portfolio management: find strategies that are good over the long term, but at different times, and combine them to a portfolio.

Conclusions and Further Ideas

As I mentioned earlier, the whole US vs. International question really fascinates me. I think part of the reason is that it really tests my beliefs. I see no logical reason why the US should continue to outperform forever, yet I have never observed something meaningfully different in my (investing) life time. I see and belief in some of the structural advantages the US has over other countries, but the arithmetic of the global average and increasing valuations are in my opinion simply facts that we cannot deny.

Against this background, I really like the subtitle of the paper’s conclusion – Doing the Right Thing is Usually Hard. Without the historical experience of the last decades, most people probably would simply go for a internationally diversified portfolio. However, it is psychologically very challenging to go with the rational advice if it loses for decades. But as the saying goes, “Just because a few people win, doesn’t make playing the lottery smart.”

In case of US vs. International, there were of course many winners over the last years. But unless you have a demonstrable argument why the US should outperform, international diversification remains the right thing. Even though it is hard and lonely sometimes…

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1 Regular readers of this blog may have recognized that I am a fan of AQR’s research. I stand by it…
2 Full disclosure: I am one of the stupid-looking folks…
3 Given the large share of US equities in global benchmarks, a home bias is of course not as severe for US investors.
4 See for example Asness et al. (2013).