The Benefits and Risks of International Investing
As we just covered above in the Portfolio Impact of Asset Classes section, adding international investments can provide both return enhancement and diversification benefits. But there are both pros and cons of international diversification that you need to be aware for the L3 exam.
The diversification benefits happen because international markets are often less correlated, while greater returns are possible because international (especially emerging) economies are growing faster than more developed economies. This pushes the Efficient Frontier up and to the left:
Some of the reasons different markets may have low correlations, i.e. behave differently include:
- Cultural/sociological differences
- Technological specialization
- Fiscal/Monetary policy
International Investing Risks
While international investing can diversify our portfolio and reduce risk it also carries additional qualitative risk factors that we need to consider. These include:
- Currency risk – Exchange rate fluctuations affect size and volatility of return. Over long-term this may not be as significant an issue as it appears (see below).
- Lack of information - Harder to get accurate info, home country bias means investors may not put in required time to understand a different market
- Political risk – Lack of responsible fiscal/monetary policies, weak legal structures, discriminatory practices such as taxes on foreign investors, or simply instability
(See more on how to manage overall risk in our Risk Management Principles post)
Why Currency Risk Isn't a Big Deal
It is common sense that currency movements could affect returns from investing across different countries. That’s OK, it doesn’t add as much risk as you might think. That’s because you can diversify across a basket of currencies and asset returns and currency risk can partially offset. Formally:
- Correlation between the asset return in local-currency and change in currency value will be less than one
- In a global portfolio the average correlation across currencies will be less than one
- Currency risk declines in significance over long time horizons
In our full CFA Level 3 notes we go into the specific math of currency effects and how to hedge it in more depth.
The Costs of International Investing
In general the cost of trading international securities will be higher than trading domestic ones. Several factors can drive this:
- Taxes: Many international countries impose withholding taxes on foreign investors
- Liquidity: Emerging markets are less liquid. Higher bid-ask spreads can increase trading costs (the curriculum calls this market impact costs)
- Transaction costs and management fees: These tend to be higher for international investing.
- Political risk
- Currency risk
- Lack of familiarity
The Case for and Against International Diversification
Advocates for international diversification have stressed its potential for higher returns, lower portfolio risk, and higher Sharpe ratios. These proponents have also stressed the benefits of investing in countries with different dominant risk factors and return drivers. While these benefits are widely acknowledged, more recent evidence has challenged some of these assertions.
The challenges come from two main directions.
- Diversification may actually be decreasing as global markets converge. And when correlation between markets increase, diversification becomes less useful.
- Some studies have shown that the diversification benefits of international investing may be overstated because it is least effective when investors need it most.
Let’s explore both of these arguments in more depth, starting with the variability of diversification.
Market Volatility Decreases Diversification Benefits
This variability argument attacks the traditional diversification thesis by showing that market volatility increases correlation. In other words the extent to which markets are diversified, or have low correlation with one another, is conditional. In certain times of crisis, when markets have greater volatility, the traditionally low correlation between international investments and a domestic portfolio can become much higher.
If the diversification benefits shrink during these crisis times, then the portfolio benefits of adding international investments may actually be lower than traditional theory indicates. Mathematicians have determined, however, that the increase in correlation is just a product of the mathematical way it is calculated. So while volatility increases correlation, this appears to be a statistical aberration. True correlation may not actually be increasing. Another way to look at if markets are moving together is to look at cross-sectional standard deviations of a portfolio. If they are large, then the markets are still moving independently.
The World is Getting Smaller
The other argument that deemphasizes the benefits of international investing centers on the fact that global markets are converging. It is true that the correlation between markets has increased over time. This seems to be happening for three primary reasons. First, we have more open borders and increased trade. Second, capital markets have become integrated and more mobile meaning capital flows are less impeded. Finally corporations have become more multi-national in terms of exports, operations, and M&A activity.
The Benefits of International Investing
Despite these challenges, international investing is still considered a strong benefit to a portfolio because:
- Foreign markets may offer better valuations
- Over the long term a global portfolio offers better hedging against local events
- Global bond markets have lower correlation than the equities markets offering even greater diversification benefits
- No single country’s market will consistently outperform all the rest over time
In addition to what is presented above, the CFA Level 3 exam will invariably bring up these concepts via calculation questions centered on the Singer and Terhaar model. The curriculum also has substantial discussion of the particulars around investing in emerging markets which build on this discussion but offer unique testable material as well.
 Note that there is also a difference between international and global investing. Global investing is explicit about diversifying across industries as well as countries, whereas international investing is only concerned about geographic diversification.