Why geographic diversification still matters
Given all the volatility that’s been occurring in world markets after the Brexit vote, I’ve been asked whether it would be better to stick to Canadian stocks? After all, Canada is economically and politically stable, and so it would seem to be logical to invest in equities in a “safe” place. But that’s actually something of a fallacy.
While it might be nice to think that Canada’s banks, grocery stores, mines, telecommunications firms, and auto manufacturers are insulated from the ebbs and flows of global markets, it just isn’t so. Capital knows no boundaries (and probably never has). In our hyperkinetic, hyper-interconnected times, it just moves around a lot faster. In addition, the last three or four decades have seen a liberalization, realignment, and massive increase in the global trade structure. Goods, services, and materials travel around the world at speeds unimaginable a generation ago – those blueberries you buy today at the local Superstore were picked two days ago in California or Mexico or Argentina. And it’s all supported by a complex and highly integrated global financing mechanism, in which virtually every Canadian business is involved to some degree.
Circling the wagons won’t help
So, really, it makes no sense to circle the wagons and “invest at home” if things get rocky in the short term. In fact, there’s an investment term for that sort of approach: home bias. It’s regarded by portfolio managers as a definite weakness in asset allocation, because it negates the key principle of reducing overall portfolio risk through geographic diversification.
Does it really make a difference? It does, and you don’t have to look far to see why. Let’s use three broad-market iShares exchange traded funds (ETFs) as proxies for the Canadian, U.S., and European/Far East markets. For the period ending May 31, the three-year compounded average annual rate of return and average standard deviation (a broad measure of risk) for each of these funds tells the story. I’ve chosen Canadian dollar hedged funds for the foreign markets to remove exchange-rate risk from the equation:
iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC): 3-year annualized return: 6.65%; 3-year average standard deviation: 8.90%.
iShares Core S&P 500 Index ETF (CAD- Hedged) (TSX: XSP): 3-year annualized return: 10.59%; 3-year average standard deviation: 11.45%.
iShares MSCI EAFE Index ETF (CAD-Hedged) (TSX: XIN): 3-year annualized return: 5.37%; 3-year average standard deviation: 12.01%.
Searching for non-correlated markets
By investing only in Canadian equities, you would have given up on some of the approximately four percentage point extra return that U.S. equities delivered over Canadian equities. By the same token, the lagging return on the EAFE ETF would have dampened total portfolio returns, but at least you would have been holding an asset with less correlation to the other two, which makes a difference when some markets are broadly declining and others are not. For example, through 2015, while the S&P/TSX and the S&P 500 ETFs steadily declined in value, the EAFE ETF rose.
You can check your own portfolio in a similar way to see how geographically diversified your holdings are. You’ll quickly see whether your portfolio is overweighted in one geographic region. If so, you can take appropriate action to “rebalance.” Rebalancing is an art in and of itself, because it involves selling selected assets in one category and purchasing assets in another. Of course, this can have tax implications, as well as transaction costs.
If you invest mainly through mutual funds and ETFs, remember that many are already diversified internally. However, you can get a preliminary fix on the broad sector of your mutual fund or ETF by checking which fund category it is placed in. In Canada, one widely-used fund category system is administered by the Canadian Investment Fund Standards Committee (CIFSC).
As for individual portfolio holdings, each fund breaks down its holdings by category, sector, and region, all of which can be found in handy fact sheets available under the fund name of the over 36,000 funds and clones tracked by Fundata and available on the Fund Library website.
© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.