International Investors: Don't Forget About Sector Diversification
Most investors are strongly biased in favor of their home country, despite well-documented benefits from international diversification. Billionaire investor Warren Buffett is a notorious advocate of buying and holding only a low-cost S&P 500 index fund.
The problem is that the so-called ‘home bias’ exposes investors to a lot of risk in the form of sector concentration. For example, the S&P 500 may generate nearly half of its revenue from outside of the United States, but the tech sector accounts for nearly 21% of the portfolio. A downturn in the tech sector could be catastrophic with individual companies like Apple Inc. (AAPL) accounting for more than 3% of the portfolio, as of August 2016.
In this article, we will take a closer look at home bias and how investors can mitigate the risk through international diversification.
Two Kinds of Risk
The S&P 500 index’s performance over the past several decades has been stellar in comparison to the rest of the world. While it’s easy to assume this growth has been evenly dispersed, a quick look behind the cover reveals that the technology sector has dominated the index’s weighting and has been a key driver behind its growth. The S&P 500’s correlation with the tech industry has been 0.78, compared to just 0.33 for the finance industry since 1993.
It’s interesting to note that a sector’s stated weight may not be fully indicative of an index’s real exposure levels. For example, the MSCI Canada index is only weighted about 20% in energy, but its returns have a very strong correlation with the energy sector. The reason is many non-energy sector companies still rely on energy prices in determining their growth. For instance, Canadian banks may rely on loans to energy companies to drive their growth rates.
Many countries are overexposed to a specific sector or tend to correlate with a sector since economic theory necessitates specialties. International investors should be aware of these dynamics when constructing their portfolios — especially when analyzing the level of diversification in their home country. High levels of exposure to a specific sector mean that a downturn in that sector could adversely impact the entire portfolio.
International investors can ensure their portfolio is properly diversified by looking at a combination of sector weights and correlations. While it’s not always appropriate to maintain equal weightings for sectors, investors should at least be aware if their portfolio is overly exposed to or correlates too closely to specific sectors. If this is the case, a downturn in these sectors could produce an unexpected downturn in the entire portfolio.
The first step is taking a look at how much weight each sector holds in a portfolio. For those with a portfolio of individual stocks, Morningstar’s free Instant X-Ray tool is a quick way to determine sector weights in the context of international weightings. Those with exchange-traded funds (ETFs) may have to look at each fund’s prospectus to determine sector weightings and then weight those values by the ETF’s percentage of the overall portfolio.
The second step is looking at a portfolio’s correlation with various sectors. For those looking for an online tool, InvestSpy can quickly calculate correlations for entire portfolios. Those looking for a more comprehensive solution may be better off using Microsoft Excel to compare their portfolio returns with those of various sector returns and calculate correlations. Statistical applications like R or Python may also be helpful in running these analyses.
The Bottom Line
International investors should keep in mind that investing in other countries doesn’t diversify away all types of risk. When it comes to sector concentration risk, investors should take a close look at their portfolio’s exposure to each sector. It’s equally important to look at the correlation with each sector since weightings don’t take into account an economy-wide reliance on a single sector — such as energy, technology, or commodities.