Does International Investing Still Deliver Risk Reduction?

Dr. Leila Heckman, Senior Managing Director Dr. John Mullin, Managing Director

SEPTEMBER 2007

Bear Stearns Active Country Equity

This paper analyzes the risk/reward benefits of incorporating foreign equities into a US stock portfolio.

Does International Investing Still Deliver Risk Reduction?

In the early 1990s, it was often argued that the inclusion of international equities could enhance the return potential of a stock portfolio, while simultaneously lowering return volatility. This was based on the analysis of returns and correlations during the 1980s.

Graph 1 shows the efficient frontier, or the trade-off of risk versus return, for portfolios including different proportions of foreign and US equities during this period. Graph 1: Portfolio Combinations MSCI US Prime Market 750 Index and MSCI EAFE Markets Risk vs. Return Trade-Off January 1980 - December 1989

Notably, returns would have been highest if 100% of the portfolio was invested abroad (as represented by the MSCI EAFE Index), with an annualized return of 23% for the period. In contrast, a portfolio investing only in the US (represented by the MSCI US Index, which has similar return characteristics to the S&P 500) returned only 17%.

Also, and more importantly, the addition of international equities to the portfolio helped reduce portfolio risk (i.e., volatility), up to a point. With 40% foreign stocks and 60% US stocks, portfolio volatility would have been minimized, while still improving on the returns of a US-only portfolio. During the 1980s, investors could have their cake, and eat it, too.

Then, the 1990s saw the dog days of international investing. Japan, the largest component of the MSCI EAFE Index, entered a secular bear market, while US stock indices embarked on a technology, media, and telecommunications boom. One side of the diversification argument still held international investing tended to reduce the volatility of a stock portfolio up to a point. However, an increased proportion of foreign stocks was not return enhancing at all. In the 1990s, the efficient frontier graph inverted itself, at least in terms of returns (see Graphs 1 and 2). Graph 2: Portfolio Combinations MSCI US Prime Market 750 Index and MSCI EAFE Markets Risk vs. Return Trade-Off January 1990 - December 1999

Source: MSCI.

1 The MSCI US Prime Market 750 Index represents the universe of large and medium capitalization companies in the US equity market. This index targets for inclusion 750 companies and represents, as of October 29, 2004, approximately 86% of the capitalization of the US equity market. The MSCI US Prime Market 750 Index is the aggregation of the MSCI US Large Cap 300 and Mid Cap 450 Indices. 2 The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure equity performance in the developed markets, excluding the US & Canada and the global emerging markets. The index includes 21 developed country indices and is calculated with dividends (net of estimated withholding taxes) reinvested. The indices are unmanaged, includes the reinvestment of earnings and do not reflect transaction costs or management fees and other expenses. Unlike the indices, a portfolio is actively managed and may include substantially fewer securities than the number of securities comprising the indices, and may have volatility, investment and other characteristics that differ from the strategy. Investors cannot purchase interests directly in an index.
2 Bear Stearns Asset Management

Source: MSCI .

Does International Investing Still Deliver Risk Reduction?

(continued)

In recent years, the validity of risk reduction and return enhancement from international diversification has been called into question. It seems that US and international stocks are moving more in sync with one another. Risk reduction from international diversification derives mostly from the historically low correlations between US and foreign markets. However, while correlations between the MSCI US and MSCI EAFE indices have varied over time, they have generally increased since the late 1990s. This is due to the tech bubble, the increasing globalization of capital, and instantaneous communication of news. Correlations between the US and MSCI EAFE reached their peak in 2005 (see Graph 3). Graph 3: MSCI US Prime Market 750 Index and MSCI EAFE Markets Trailing 36 Month Correlation of Returns December 1972 - August 2007

Conclusion

We think the case for diversification from investing abroad still holds up. In spite of some increased correlations, the US and foreign markets are not 100% in sync. Graph 4 (below) shows the efficient frontier graph of the MSCI US and MSCI EAFE markets based on data between January 2000 and August 2007, or a more contemporary data set. Here the minimum risk is achieved with a 50% US and 50% EAFE stock portfolio. Bottom line: We believe even with the increased correlations around the world, the volatility reducing benefits of adding foreign equities to a US stock portfolio should continue, as long as US and international equity markets are not perfectly correlated. Graph 4: Portfolio Combinations MSCI US Prime Market 750 Index and MSCI EAFE Markets Risk vs. Return Trade-Off January 2000 - August 2007

Source: MSCI.

Source: MSCI.

The references to hypothetical asset allocations do not refer to any portfolio actually managed by BSAM during the time periods presented. Indexes are unmanaged, include the reinvestment of dividends and interest and do not reflect transaction costs or management fees and other expenses. Investors may not purchase interests directly in an index.

Bear Stearns Asset Management