International diversification is rising, but still slow

April 23, 2014

April 23 (Reuters) – U.S. retirement savers are increasingly
diversifying into international equities, but are still leaving
much of what has to be considered a free lunch on the table.

A new study of 3.8 million U.S. savers in 401(K) retirement
accounts over the 2006-2011 period shows a general trend towards
better diversification internationally, but with most accounts
still significantly under-diversified.

And yet, given the diminishing share of U.S. companies in
global equity capitalization, they are, as a group, far less
diversified than they ought to be.

“One key fact emerging from the data is that there is an
upward trend in the extent of international diversification. We
show that part of this, but only a small part, is he potentially
rational response to the slowly decreasing importance of the US
market in the world equity markets,” according to the study’s
authors, Geert Bekaert and Enrichetta Ravina of Columbia
Business School and Kenton Hoyem and Wei-Yin Hu of Financial
Engines, a retirement advice company which supplied access to
the data. ( here
)

The average international equity allocation is now 17.8
percent, with 17 percent holding no exposure at all to the asset
class. Given that 64 percent of all global equity capitalization
is now outside the U.S., that’s a huge underweight.

Diversification in general is critical to investment
performance, reducing volatility while increasing returns.

Diversification internationally of equities is particularly
important because the U.S. over time, while it may perform very
well, will inevitably see its share of global output and equity
value decrease. This is not simply about expectations of higher
growth rates elsewhere, but also about deepening capital markets
in emerging countries and falling costs to access them.

A variety of reasons have been proposed for why savers tend
to stay close to home – familiarity, cost, consumption and
currency risk, and the feeling that the investor will be at a
disadvantage to investors closer to the companies and markets on
which they trade.

Some measure of international under-diversification is to be
expected, and may indeed be wise. To simply hold shares relative
to their global weight exposes the investor to real risks which
the benefits of diversification may not fully cover,
particularly currency risk.

U.S. investors are saving to meet dollar-based liabilities,
and so theoretically dollar assets have an extra value not fully
expressed in investment returns.

Still the data on the overall benefits of diversification is
very strong. In one study by investment managers Gerstein Fisher
covering 1999-2011, a globally diversified portfolio
outperformed a U.S.-only one in 96 percent of rolling three-year
periods, with a total outperformance of 35 percentage points
over 11 years.

FAMILIARITY BIAS

Much of the Columbia and Financial Engines study backs up
the familiarity hypothesis for why people under-diversify.

For example, having an export oriented factory open up near
you seems to be a very good thing for your investment
sophistication.

The study found that states with higher relative export
components in their economies tended to also see higher
international exposure in 401(K) accounts. At the zip code
level, living in a place with more foreign-born residents also
correlates meaningfully with being more willing to hold foreign
shares.

The general news, however, is upbeat. International
diversification has increased by nearly 50 percent in the five
years to 2011, years which included a rather spectacular global
market fiasco.

As with many trends, the young adapt more quickly and fully
than their older peers, but all groups from the oldest to the
youngest are moving towards more international diversification
over time.

There also, as you would expect, is some correlation, though
not perfect, between being under diversified internationally and
not participating in equities at all.

The fact that younger investors seem more open to
international investing is hopeful, and the data is strong
enough to imply that the under-diversification may disappear, or
at least become less severe, over time.

To be sure, 401(K) accounts don’t represent their holders’
entire portfolio, and may also, because of the population which
holds them, give a distorted view of overall diversification.

Still, the clear implication here is that this is an area in
which financial education can play an important role and effect
a meaningful improvement in outcomes for investors at
theoretically very low cost.

International diversification is easy, cheap and works.
Investors should do it and advisors should push it.

(At the time of publication James Saft did not own any
direct investments in any securities mentioned in this article.
He may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(James Saft)

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