Across the Universe

When I meet with new/prospective clients, one of the first things I do is take a look at their current portfolio. Invariably, almost every portfolio I see has little or no exposure to companies outside the Unites States. It's as if the investing world stops at America's borders. Today, with increased globalization and decreased barriers to entry, building a global portfolio is almost always the right call.

Client: I know domestic companies and the U.S. economy, but I don't know anything at about foreign stocks. If that's the case, why bother with foreign securities?

Advisor: First, let's revisit a concept I have discussed in past columns. In my opinion, the first step in creating a successful portfolio is selecting an appropriate benchmark. In doing so, you provide yourself with a "road map" that helps you to create a diversified portfolio and stay disciplined once it is built. Over very long periods of time (say, 25 years or more), any well-constructed benchmark should yield comparable results; otherwise, investors would only invest in the one that performs best. So, if every benchmark converges to the same point, the goal should be to select an index that provides the smoothest ride, or in other words, the lowest amount of volatility.

If you're looking for a benchmark that provides a "smooth ride," you're generally going to want a broad benchmark – in fact, the broader the better. Consider two indexes – the NASDAQ Composite and the Morgan Stanley Capital International (MSCI) World Index. The NASDAQ is, for the most part, a domestic technology index. It represents one country (the U.S.) and mostly one sector (Tech). On the other hand, the MSCI World is incredibly broad, representing the 23 most developed nations in the world – i.e., the U.S., Japan, Britain, France, Germany, etc. In those 23 countries, you'll find companies in every conceivable sector, style and size. Which one do you think will give you a smoother ride? (Answer: The global one, of course).

Client: But, aren't foreign stocks risky? How does adding a risky asset class like foreign stocks make my portfolio less volatile?

Advisor: Before we get into the risks of foreign stocks, let's compare the returns of each asset class. Between 1970 and the end of 2006, the S&P 500 managed an annualized return of 11.2% and the EAFE returned 10.9%. In the long-term, that is a tiny difference.

OK, so the relative returns are pretty close – what about risk? We can compare the two classes (foreign vs. domestic) by looking at their standard deviations of returns. Risk is typically quantified by standard deviation (a measure of volatility), so the lower the standard deviation, the better. From 1970 through the end of 2006, the MSCI EAFE index (a good proxy for the developed foreign markets) had a standard deviation of 16.5%. Over the same time period, the S&P 500 Index had a deviation of 15.2%. So, in other words, you're right – foreign stocks have been "riskier" than U.S. ones over the last 30 years.

However, let's look at what happens when we create a portfolio that contains both types of securities. Over the same 37 year time frame, a portfolio of 50% U.S. stocks and 50% foreign ones (rebalanced annually) had a standard deviation of 13.9% - a figure lower than either the S&P or the EAFE on their own. When you broaden your benchmark, you increase the likelihood that you are blending assets that are negatively correlated. In other words, when something in the portfolio is zigging, something else is zagging. When you concentrate your assets in one market segment (i.e. domestic stocks), you create a portfolio that, generally speaking, "zigs" together – that's actually more risky.

Client: OK, how much should I put in foreign securities? And how do I buy foreign stocks? Do I have to start messing with exchanging currencies?

Advisor: Again, how much you put into foreign securities goes back to the benchmark you choose. As of the end of January 2007, the MSCI World Index had a weighting of about 51% to non-U.S. securities. Using that as a baseline, you then have to ask questions like "Is the U.S. going to do better than foreign next year?" or "What is attractive about Japan/France/etc.?" Based on your evaluation of each area, you may choose or put more or less of your portfolio in one particular region.

When it comes to actually buying foreign securities, you have a lot of options. You could set up a brokerage account that can trade multiple currencies, thereby allowing you to purchase companies on their home exchanges. Frankly, that is complicated, and depending on the brokerage house, could be expensive. To make things easier, you could purchase an American Depositary Receipt (ADR), which is simply a certificate representing a foreign security that trades on a U.S. exchange (i.e. the NYSE, Amex or NASDAQ). ADRs are denominated in U.S. dollars, so no currency conversion is required.

* Figures courtesy of Bloomberg, L.P. and Thomson Financial Datastream

The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.