This article was originally published 8 February 2015 on ft.com.
A discussion on the benefits of moving from a country-specific portfolio to a global one
As economists say: there is no such thing as a free lunch. That is true most of the time but diversification comes close — a cheap lunch at least.
One chart that we often discuss with clients shows the advantages of moving from a country-specific fixed income portfolio to a global portfolio in terms of returns, volatility and the all-important measure of return per unit of volatility.
The past, of course, is not always a guide to the future, but the historical data show that, over time, global portfolios have superior returns per unit of volatility than their country-specific constituent indices. For example, over the preceding three-, five- and 10-year periods, the Barclays Global Aggregate index delivered similar returns to the Barclays US Aggregate index, but with about 0.25 per cent to 0.5 per cent less volatility.
The benefits are most apparent during acute phases of market instability, which tend to originate in one particular market and affect it more than the others. Consider 2013, the year of the “taper tantrum”. Passive investors in the Barclays US Aggregate suffered the second-worst year in the history of the index, returning -2 per cent. But Japanese markets returned 1.9 per cent and European peripheral countries were rallying strongly, with Italy and Spain returning 7 per cent and 11 per cent, respectively.
Markets such as Canada and Australia may add significant ballast to a bond portfolio as they have regularly out- or underperformed by as much as 5 per cent in any given year. In fact, in the past 10 years, the largest drawdown of the Global Aggregate was about 30 per cent less than the US Aggregate and about 35 per cent less than the Euro Aggregate, demonstrating the stabilising characteristic of diversification.
In 2007, on the eve of the global financial crisis, the International Monetary Fund published research that showed that in spite of stabilisation of growth in individual economies, global economic growth had not stabilised. The IMF researchers explained this curiosity by showing the rise in correlation across countries during the period known as “the great moderation”. Because individual economies were correlated, booming and busting together, the global economy lost one of its most stabilising influences: diversification.
During the financial crisis, global economies — and asset prices — moved with high levels of correlation during the immediate slump and the 2009 recovery. But recent experience and the outlook for 2015 and the next few years suggest that divergence of economic outcomes is back — for instance, the US economy versus Europe — with the potential for this to be reflected in asset market returns.
This divergence is reflected particularly in central bank policy outcomes. While the US Federal Reserve has stopped quantitative easing, the Bank of Japan continues to expand its balance sheet and the European Central Bank is finally poised to start buying sovereign bonds in March.
In the eurozone, the overall macroeconomic challenges are great, but the country specifics require very close attention. This has provided opportunities for active investors in the past several years and we expect this to continue.
In the emerging world, the period of steady global capital flows and continuously rising commodity prices may have masked differences, but with more jittery capital markets and the plunge in commodity prices it should be clear that close attention to country specifics is crucial.
While some global capital is controlled by long-term value investors who help to damp short-term oscillations in prices, much of it is not. First, there are the reactionary investors with short-term horizons who invest with the momentum of the market. Second, there are growing numbers of passive investors tied to assets included in official benchmarks; securities that lose benchmark sponsorship suffer automatic selling and disproportionate price declines. Third, there are the leveraged investors bound by strict stop-loss limits.
All of this is good news for long-term value investors who can take advantage of assets that have been disproportionately punished (or rewarded) by global capital markets. Fundamental and policy divergence provide good opportunities for active global investors — on top of the cheap-lunch benefits of diversification.