So there I sat, cozily wrapped in my premise, when a traitorous paper arrived in the mail-asking the question “Where Are the Gains From International Diversification?” The author, Rex Sinquefield, is a respected student of markets. His titre, Dimensional Fund Advisers (DFA), in Santa Monica, Calif., runs more than $10 billion in mutual funds for institutions and clients of fee-only financial advisers. Sinquefield contends that the typical foreign funds we buy–the ones that invest in the strongest stocks in the industrial world–aren’t accomplishing what we think. Diversified international funds have not significantly improved investment returns. Nor have they materially reduced our risks. Big foreign stocks behave pretty much like big U.S. stocks. You can get more diversification from a mix of American funds alone.
Intrigued, I faxed Sinquefield’s paper to several thoughtful academics and money runners, all of whom took some shots at his views. Nevertheless, there were interesting areas of agreement.
First, foreign stock markets haven’t been running rings around the U.S. exchange s, as so many investors think. True, the popularly watched EAFE index-which tracks representative stocks in Europe, Australia and the Far East -has outperformed the American market for 20 years. But EAFE knocks your seeks off only when its gains are transposed into dollars. When measured in yen, marks and other local currencies (chart), EAFE has been growing more slowly than the Standard & Poor’s 500-stock index. So far this year, EAFE has taken a 5 percent hit in local money, compared with a spectacular 13 percent rise in the S&P. “I’ve never understood why France or even Japan is supposed to have so much more future growth potential than the American economy,” says John Bogle, chairman of the Vanguard Group in Valley Forge, Pa.
Americans are dollar investors, so we’ve done better with EAFE-type stocks than the Japanese and Europeans did. But our extra gains came from rising foreign currency values, not from fatter corporate profits abroad. Ironically, many foreign funds still underperformed the U.S. market. Their managers bought currency hedges, which neutralized the profitable dollar play.
A second area of agreement among the experts I consulted is that EAFE stocks won’t make a dramatic difference to your long-term gains. John Hussman of Hussman Econometrics in Farmington Hills, Mich., says EAFE stocks contribute “slightly higher” returns and add a bit more stability to an existing portfolio of U. S. stocks and bonds.
Sinquefield thinks that you don’t have to settle for so modest an outcome. His ideas on how to diversify:
For investors who won’t move beyond the funds that buy EAFE stocks: bring that money home. It should earn more in U.S. small-company and value funds. (“Value” stocks–often companies with troubles–sell for low prices compared with what the firm is worth.)
For investors willing to look beyond EAFE: choose the value funds and small-company funds in the international group.
How to find them? There’s the rub. Morningstar in Chicago tracks 109 retail international funds that appear to focus on value stocks. But many of them also buy growth stocks- stocks of companies with steady dividend and earnings gains –and other types of securities. The prospectus may tell you how strongly the manager hews to the value-stock strategy. As for international small-stock funds, you have limited choice. Morningstar lists only 80.
The Grail, for investors, is a mix of foreign and U.S. funds that adds to your expected returns without also adding risk. I asked DFA’s Eugene Fama Jr. to suggest some portfolios, drawn from his firm’s index funds. (An index fund tracks the performance of a specific market index.) But because most investors don’t deal with planners who use DFA, I’ve translated Fama’s recommendations into the Vanguard world. The moderately aggressive might put 10 percent of their money in Vanguard’s 500 fund, 10 percent in Small Cap, 20 percent in the Value Portfolio, 40 percent in the Short-Term Bond Portfolio and 10 percent in Trustees’ Equity-International, a foreign value fund. There aren’t any small-stock foreign index funds. So for the remaining 10 percent, two managed funds that met DFA’s specs are Founders Passport and Montgomery International Small Cap. Aggressive investors would halve the portion in bonds and add that money to stocks (with 5 percent in emerging markets).
Critic Josef Lakonishok, finance professor at the University of Illinois at Urbana-Champaign, disagrees with the small-stock allocation, which he thinks won’t perform as well in the future as in the past. William Sharpe, at the Stanford Graduate School of Business and a high priest of value stocks, thinks that ignoring growth stocks is “too extreme.” Marshall Blume, at the Wharton School in Philadelphia, finds EAFE more useful than Sinquefield allows. But all concur with his tilt toward foreign value funds. So that’s my cozy new premise. For now.
Big foreign stocks have earned more than U.S. stocks only because their value has risen against the dollar. Measured in local currencies, the U.S. stock market has outperformed those of the other major industrialized nations.
EAFE[b] EAFE[b] Time period[a] S&P 500 (IN LOCAL (IN U.S. CURRENCIES) DOLLARS) 1 year 1.3% -1.8% 8.1% 5 years 8.6 -1.7 1.8 10 years 14.3 10.4 17.9 20 years 14.6 13.9 16.8
a ENDING DEC. 31, 1994. b REPRESENTATIVE STOCKS IN EUROPE, AUSTRALASIA, FAR EAST. SOURCES: MORGAN STANLEY CAPITAL INTERNATIONAL, STANDARD & POOR’S
The story of how my pet unexamined premise finally bit the dust
