Do Multinationals Count as International Diversification?

Substituting Multinationals for International Investments is a Bad Idea

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Multinational companies sell goods and services around the world, which means that they provide a certain level of diversification for investors. For example, the percentage of S&P 500 sales from international sources increased from 24.6% to 35% between 2000 and 2010, which means that many U.S. investors may have a lot more global exposure than they might think regarding sales.

In this article, we’ll take a look at whether or not investing in these multinational companies can replace the need to diversify internationally.

Diversification 101

The prerequisite to a discussion of whether or not multinational companies count toward diversification is the very definition of “diversification.” In general, diversification is defined as the reduction of non-systematic risk by investing across a wide variety of assets. The theory is that investing capital across many assets can reduce the risk associated with any single investment.

In the case of international diversification, the idea is that investors can reduce the risk of U.S.-related downturns (non-systematic risk) by investing across several different countries. Multinational corporations deriving a lot of their income from foreign sources would presumably provide such diversification since their revenue growth, and profitability isn’t necessarily dependent on the U.S.

The benefit of diversifying through multinational corporations – rather than internationally – is that these companies trade on U.S. exchanges and are subject to U.S. laws.

Also, these companies tend to have more consistent dividend policies and higher profit margins due to their maturity relative to smaller international companies operating in emerging markets.

Multinational v. International

The theory may be sound, but the practice is a bit cloudier. Many multinational companies tend to move in tandem with U.S. stocks, which defeats the purpose of diversification in general (designed to reduce correlation between assets).

Most of these firms still derive a high percentage of their profits from the U.S., which means they have a lot of exposure remaining to the U.S.

Multinational companies tend to hedge their currency exposure to provide a clearer reading of profits regarding U.S. dollars. While this may be preferable to domestic investors, it’s counterproductive for diversification, where international investors want to see exposure to international currencies in case the U.S. dollar runs into problems.

Finally, large multinational companies provide investors with exposure to only the large-cap portion of the international markets. Often, small-cap and mid-cap stocks provide better exposure to foreign economies and are more tightly coupled with the countries’ economic performance. A great example of this is the increased volatility in small-cap versus large-cap stocks all else equal.

Properly Diversifying Abroad

The good news is that investing internationally no longer involves setting up foreign brokerage accounts and dealing with currency conversions. With international exchange-traded funds (“ETFs”), U.S. investors can build instant exposure to international markets into their portfolio with a single U.S.-traded security that holds a basket of foreign stocks.

The most common way to gain international exposure is to invest in all-world ex-U.S. funds, which hold equities in a variety of different countries with the exception of the United States. For those looking for more specific exposure, there is a number of ETFs targeting specific regions or markets – such as emerging markets – or even individual countries.

Before investing in international ETFs, investors should carefully read the prospectus and pay especially close attention to the expense ratio (how much the fund charges each year for managing the portfolio) and the level of diversification regarding individual holdings or sector exposure. The best ETFs have low expense ratios and relatively diverse holdings.

Key Takeaway Points

  • Multinational companies may derive a portion of their profits from international markets, but that doesn’t mean they can be substituted for international investments in a portfolio.
  • International ETFs represent the easiest way to build international exposure the proper way, but investors should carefully consider expense ratios and company/industry exposure.