International Equity Investing: Is Flexibility the New Diversification?

Abstract

Global cross-country correlations have increased significantly across asset classes over the last two decades. This article documents systematic links between correlations of capital markets and the globalization of the real economy that suggest that higher correlations will persist and challenge the traditional role of international equities as a domestic diversifier. The authors argue that the case for international investing increasingly rests on the return potential from investing in a broad set of companies and that flexibility to invest across borders is key to capturing this value. They test this thesis with an empirical analysis of mutual funds and find that strategies with fewer geographical restrictions have indeed generated superior returns. The authors find benefits of flexibility in US funds that invest internationally, international funds that invest in the United States, international funds that invest in emerging markets and in global funds. Their results hold consistently in the ex post analysis of average and top-quartile strategies and when they use simple screens to identify and evaluate skillful managers. Interestingly, the authors find that improved results are driven by superior stock selection, as opposed to systematic regional tilts or market timing.

TOPICS: Global markets, mutual funds/passive investing/indexing