There are a variety of concerns with international investing and limitations of the analysis cited in previous sections. These limitations are discussed below and may weaken the case for international investing.

Increasing and Varying Correlations

Concern

The key benefit from international investing arises because of low correlations between the domestic market and foreign markets. There are two criticisms of historical correlations. First, the correlations may be increasing due to greater global integration as evidenced by larger capital and trade flows. Moreover, as more and more emerging markets liberalize capital flows, the correlations will increase. If the correlations are increasing, the above analysis based on prior data overestimates the benefit from international investing. Reconsider the example in the preamble of “Evidence,” above. With a correlation of 0.60, the new portfolio’s risk fell from 18 percent to 16 percent. However, if the correlation is 0.70 instead of 0′:60, then the new portfolio’s risk falls less, from 18 percent to 16.6 percent. If the correlation is 0.8, then the risk is 17.1 percent.

You can see that the gains from international investing can quickly erode with an increase in correlations.

The second criticism stems from evidence that suggests that correlations increase in times of booms and crises. Since risk diversification is most useful and critical when markets are in a decline or in turbulent markets, increasing correlations at those moments make international investing less attractive. For example, all markets fell together during the 1974 oil price shock, the 1987 stock market crash, the 1991 Gulf crisis, and the 1997 East Asian currency crisis. Clearly, the higher correlation in times of crisis is not desirable.

Rejoinder

From Table 10.2, the average correlation is 0.58 for the developed markets and 0.42 for the emerging markets. The different periods considered in “Risk of International Investing” suggest that correlations vary between 0.20 and 0.70 for pairs of developed countries and that the range has not varied much over time. In any case, how high can the correlations go? The United States and Canada are probably as similar as two countries can be and trade a lot. However, the correlation has hovered around 0.70. The same thing is true of Switzerland and Germany. Thus, there seems to be an upper bound to how correlated U.S. markets and foreign markets can become.

Why is there an upper bound? The answer is in the two sources of diversification that cause the countries to be less than perfectly correlated. The first source is based on differences in the political and economic environment of different countries. The second source of low correlation is differences in the industrial makeup of countries. The argument goes as follows: the political outlook and economic structure of a country is important because a centrally planned economy will behave quite differently than a market-driven economy. Changes in the political climate do not affect more than one country or region. For instance, political turmoil in Indonesia may affect Singapore and Malaysia but is unlikely to affect the U.S. stock market. The political relationship between North Korea and South Korea is unlikely to have an effect on European markets. Similarly, national stock markets may continue to remain poorly correlated if those markets consist of different industries. For example, a country that specializes in textiles cannot be highly correlated with the U.S. stock market, which consists of high-tech and service-oriented industries.

Moreover, while globalization can increase correlations among countries due to integration, globalization can also lead to lower correlations. With greater trade and globalization, countries tend to specialize in industries depending on comparative advantage, their natural resources, labor skill, wages, and so on. As the developed countries move more toward services and concentrate on innovations, they will import more of other products. Therefore, globalization makes the countries more different due to specialization. This specialization in industries suggests that it is unlikely that the industrial base of countries will converge, and hence the stock markets are unlikely to become highly correlated.

The jury is still out on the relative importance of the two sources of diversification. Are differences in political and economic environment more important than differences in the industrial structure of countries? Whatever the cause, it is easy to see that countries will remain less than well correlated for a long time. From a historical perspective, global trade as a percentage of GDP was at a significantly higher level in the early 1900s than today, but the correlations among countries were not high. Individual country correlations have bounced around and increased a little, but the EAFEU.S. correlations have remained between 0.50 and 0.60.

On the other hand, the correlations between emerging markets and the U.S. market are likely to increase as the emerging markets become more open to foreign capital flows. However, these correlations do not increase continually. Take the 1984-93 period. The correlation between the U.S. and a composite of emerging markets was 0.34 for 1984-88, but it fell to 0.20 between 1988 and 1990 and then to 0.19 for 1991-93. Though there is an increase in correlations, they will probably stagnate around 0.40 and 0.50. A low level of correlation with emerging markets is appropriate due to large differences in economic conditions and prosperity.

The second concern relates to higher correlations in times of crisis. There are two responses. First, other studies question the reliability of this finding and state that correlations only seem to be higher and in fact are actually the same. Second, the correlations mentioned above and used in calculations include both highly volatile and normal times. Since any equity investment, including international equity investment, ought to be long-term, very short-term correlations are not relevant.

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International Investing Concerns and Limitations Part 1

• International Investing Concerns and Limitations Part 2
• The Origins of the Futures Industry (part 4)
• The Origins of the Futures Industry (part 2)
• Money under Management
• Regulation of Managed Futures Funds in Europe Part 1
• The Origins of the Futures Industry (part 3)
• Gaining Profile—Press Relations
• How to Fulfill the Futures Contract Promise
• Inside of the foreign exchange market
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