Should You Look at Sectors or Countries When Diversifying Abroad?

Country vs. Sector ETFs for Diversification

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Most investors are familiar with the benefits of diversification, but they may not be as familiar with the actual mechanics. While early research found that low cross-country correlations reduced portfolio risk, the lowering of trade barriers, emergence of the European Union, and integration of world markets has led to rising correlations between U.S. and non-U.S. equity markets, especially during economic crises when diversification is needed the most.

These rising correlations have led to a growing body of research on global sectors and industries. Many researchers believe that the industrial composition of a country’s economy plays an important role in the correlation structure of its returns. International investors may want to consider investing based on the merits of global sectors, as well as investing in various countries to minimize risk and maximize diversification.

Rising Equity Correlations

Equity markets have become increasingly correlated over the past two decades. According to Vanguard research conducted between 2003 and 2008, average company correlations versus the United States range from a high of 0.47 for Europe to a low of 0.25 for the Pacific Rim. Japan has an unusually low 0.12 correlation with the U.S. Surprisingly, average correlations for emerging markets were 0.40 for both Africa/Middle East and Latin America.

These correlation coefficients are much lower than same-country correlations, but the benefits of diversification have tended to decrease over time. The difference between developed and emerging market performance also tends to matter less than specific countries or regions, such as Japan and the Pacific Rim region, that may offer greater diversification. Investors should consider these factors when diversifying their portfolios.

The researchers also found that U.S. multinationals had a 0.43 correlation with U.S. indexes, while non-U.S. multinationals had a 0.41 correlation. By comparison, foreign local corporations had a correlation of just 0.29 with U.S. indexes. These data points suggest that investors may want to focus on small to medium sized local businesses rather than foreign multinationals when trying to effectively diversify their portfolio.

Country vs. Sector Effects

The most important question for investors then becomes: Does the country or industry composition of the country’s economy effect returns? In other words, should investors seek to invest in a basket of countries or focus more on global sectors? Or both? Initial research in the 1990s suggested that country effects were larger for equally-weighted returns and sector effects were larger for market weighted returns, but that may be a little misleading.

By separating the influence of sectors on country indexes, Vanguard researchers found that the relative importance of country versus sector effects tended to change based on several different factors. The lowest country-factor results occurred in the United States, United Kingdom, and France, while the highest country-factor results were Ireland, Greece, and Finland. Pacific Rim countries also tended to have greater country effects than other countries.

Global sectors have a more significant impact on equity returns for multinational companies and companies in North America and Europe. Meanwhile, country factors are important for local companies, emerging markets, and companies located in the Pacific Rim. Investors should carefully consider these dynamics when building out their portfolio to maximize diversification and avoid some of the common pitfalls.

Tips for International Investors

International investors should consider investing broadly across both countries and sectors to minimize their risk and maximize diversification. Rather than treating every country equally, investors should also focus on those that offer the most diversification to realize the maximum benefit. Investors in North America and Europe may want to consider diversifying across sectors rather than regions and vice versa for emerging markets.

The easiest way to obtain exposure to these different countries and sectors is through exchange-traded funds (ETFs) that provide a diversified portfolio in a single U.S. traded security. While there are many American Depositary Receipts (ADRs) available, they are largely limited to multinational companies that may not offer as much diversification for U.S. investors. Mutual funds are also available but tend to have higher expense ratios.

When looking at these ETFs, investors should carefully consider the funds’ target exposure, turnover, and expense ratio to make sure it fits in with their existing portfolio. Many ETFs will also have a correlation coefficient available relative to the S&P 500 that can provide an easy way to determine diversification at a glance.