Wednesday, 26 August 2009

International Diversification for the Canadian Investor: partial evidence

There is much published material on how international diversification benefits US investors but surprisingly little on the topic from the perspective of a Canadian investor. While one would normally expect that results from one country will be repeated elsewhere, as with so much else in investing (e.g. mutual fund MERs are too high, bonds return less than stocks over the long run), it is always worthwhile to look specifically at the Canadian experience.

In 2007 two graduate students from Simon Fraser University, Lei (Jeff) Wang and Luoxin (Peter) Wang took a look at the period 1996-2006 in their thesis Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test. They wanted to figure out how much benefit could be obtained from international diversification in recent years given the rise in world economic integration and the convergence of stock market returns, which we all observed last autumn as markets crashed together in perfect unison. They took account of currency shifts to estimate real returns for portfolios optimized using equities and/or bonds from the USA, UK, Japan and Hong Kong combined with Canadian stocks, bonds and T-bills/cash.

Their results are positive but less strong than I would have hoped or expected. Despite correlations that did not exceed about 0.7 amongst any of the asset classes and a number of negative correlations (especially bonds vs stocks), the benefits of both return enhancement or risk reduction (aka reduction of volatility / standard deviation) were quite modest. The main benefit came from the addition of international bonds, which provided a hedge against inflation for the Canadian investor. The optimized portfolios they came up with are decidedly unusual - most have a 0% weight in US equities and not a single one has any UK or Hong Kong equity component.

Part of the problem with the weak benefit they found is that, as they note, in this particular period of 1996-2006 the Canadian stock market outperformed everyone else's. That may not, probably will not, be the case forever, especially since the Canadian stock market is so concentrated in only three sectors - financial services, resources and energy. Thus, diversification should work better over a longer period in the future than their results show. A second point worth considering is that they found a fairly significant inflation-hedging benefit during a period when inflation in Canada has been consistently low. That also may not be true forever. It's good to have a supplement to real return bonds as an inflation hedge. The final point, which they do not discuss and which is probably significant, is that their portfolio construction method included no rebalancing. They calculated the single optimal portfolio for the duration. Rebalancing provides the "buy low-sell high" mechanism for enhancing portfolio returns and reducing risk. Perhaps they can do a PhD to do more calculations.

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