This In Practice piece gives a practitioner’s perspective on the article “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” by Cormac Mullen and Jenny Berrill, published in the Second Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
The assumed benefits of international portfolio diversification have long been part of the smart investor’s toolkit. Many investors continue to diversify their portfolios internationally despite evidence that today’s markets are more correlated as economies have become more globalised and homogeneous.
For example, in 1995, a US investor in Vodafone, the UK-based telecommunications company, was investing in a group with 99.7% of its sales in the United Kingdom. The same investor in 2012 held shares in a group with just 8% of its sales in the United Kingdom but some 30% in the United States, the investor’s home country. That’s to say, 20 years ago a foreign company’s sales were expected to be mainly made in its home country. Today, however, sales are more multinational, so investors often do not receive the diversification benefits they expect from investing in foreign companies.
Amid many such examples, a number of investors and fund managers now make allocations to emerging and frontier markets to enhance diversification in their equity portfolios. But this is not attractive for more risk-averse investors and investment managers whose investment mandates do not permit investments outside of developed markets.So, is there a way to achieve meaningful international diversification while still investing in developed-market companies? The authors examine the case for investing in foreign companies that make most or all of their sales in their own countries.
How Do the Authors Tackle the Issue?
The authors seek to establish if portfolios of foreign companies with high levels of sales in their home markets outperform portfolios of companies with predominantly regional or global sales. They do this using a methodology—with data from 10 developed countries—that incorporates the size, scope, and location of international companies and their sales.
They then analyse the diversification benefits of the various categories of firms that this methodology produces. These categories are as follows:
• Foreign, domestic-only companies, which have 100% of their sales in their home country
• Companies with sales concentrated in their home regions—for instance, North America, South America, or Europe
• Companies with sales concentrated in foreign regions
• Bi-regional companies, which have most of their sales in two principal regions
• Global companies, which trade in many regions
The authors compare the international diversification benefits of portfolios created from these categories. The portfolios are backtested over a 15-year period, from 1998 to 2012.Finally, the authors measure the international diversification benefits and perform a Sharpe ratio analysis—which measures performance in relation to the risk taken—to assess any portfolio benefits.
What Are the Findings?
Overall, investing in foreign equities offers statistically significant diversification benefits to all but US and UK investors. The likely reason that US and UK investors gain no benefits is that domestic stocks in these countries are predominantly multinational and thus already contain significant exposure to foreign markets. So, broad diversification by US and UK investors offers no additional advantages.
The greatest diversification benefits are felt by Belgian and Japanese investors: Belgian investors experience a 67.3% increase in the Sharpe ratio compared with a local portfolio of shares; Japanese investors enjoy a 37.6% increase. For other eurozone investors, the Sharpe ratio improvement ranges from 8.6% for French investors to 36.4% for Dutch investors.
In other words, international equity exposure does still offer diversification benefits for investors in many countries, despite evidence elsewhere of a weakened argument. Diversification benefits can be significantly improved by concentrating on domestic-focused foreign stocks.
In 9 of the 10 countries, the largest change in Sharpe ratio for an international portfolio comes from adding foreign domestic stocks. The changes range from a 39.5% increase for US investors to some 121.7% for Belgian investors. Canada is the exception, with no economic diversification benefits—the strong performance of Canadian stocks over the period analysed probably explains this anomaly.US and UK investors can improve diversification in international equity allocations by adding foreign domestic stocks, suggesting that stocks with the lowest sales exposure to an investor’s home region offer the highest international diversification benefits.
What Are the Implications for Investors and Investment Managers?
Global economic integration seems to have decreased the international diversification opportunities available to investors, but the sales exposure approach in this study offers a potential solution. Rather than portfolio managers delegating the diversification of their portfolios’ international exposures to the activities of underlying corporates, investors can isolate national exposures more precisely to feed into their diversification models. For investment managers, a portfolio of international stocks classified as “domestic” offers the potential for greater international diversification benefits than a portfolio of stocks whose sales are regional or global.
Identifying foreign stocks with a strong domestic focus requires a change in methodology for fund managers’ stock selection, portfolio management, and performance measurement processes. The authors suggest that a geographic end-market sales analysis at the stock selection and asset allocation stage of the investment process could increase diversification. They do acknowledge the limitations of geographic sales data given the accounting flexibility companies have in reporting the locations of their sales.
In addition, the authors believe their findings offer the potential for exchange-traded-fund providers to develop ETFs of equities with sales concentrated in their domestic markets. These ETFs, they suggest, could be labelled “mononationals.”
Investment firms wishing to develop a strategy based on this study may want to additionally investigate how the diversification benefits brought by foreign domestic companies can be balanced against the risk levels associated with these companies. Diversification benefits should be viewed and analysed idiosyncratically against currency risks, interest rate risks, and so on.As a final thought, investors might want to consider whether investment managers—even those using an enhanced diversification process as described in the study—are the best route to international diversification. For example, multinationals—with their tax advantages, economies of scale, and general know-how—could provide a better source of diversification. We offer this as food for thought in discussions between investors, advisers, and fund managers.