Investing internationally: Does it truly diversify?

In the world of investments, diversification is a widely endorsed strategy to mitigate risk and maximise returns. Yet, an equally critical dimension is geographic diversification, which involves investing in international equities.

Conventional wisdom suggests allocating a third of your equity portfolio to foreign markets. Yet, our readers ask - does spreading your investments across different regions of the world truly deliver the promised benefits in today's interconnected global economy? Let's find out.

The nature of equity across borders
Whether investing in domestic or international equity funds, you're essentially putting your money into equities. On the surface, it might seem that the asset class is the same, be it a share of Tesla in the US or Tata Motors in India - after all, it is equity.

But here's the nuance: even within the same class of assets, equities can behave very differently based on their geographic locations.

The paradox of globalisation
The digital age and globalisation have brought markets closer than ever. When Wall Street sneezes, it's not unusual for Dalal Street, or other global markets, for that matter, to catch a cold.

Look at the chart, and you'll notice a striking pattern: during the 2008 'Global Financial Crisis', the markets seem to be moving together. Both the S&P 500 index and the S&P BSE Sensex index saw declines in eight out of 12 months.

However, in those eight months, the S&P 500 generally weathered the storm better, managing smaller declines than the Sensex, with November as the sole exception to this trend.

While it's true that crises can make global markets move in tandem temporarily, the long-term correlation isn't as tight as one might assume.

Consider the instances when the S&P BSE Sensex experienced a downfall, particularly when the index reported calendar monthly returns below zero. How did the S&P 500 respond?

Historical data reveals that since the beginning of 2013, Sensex went negative about 52 times. Out of these, the S&P 500 also saw declines 32 times. This suggests that in 38.46 per cent of the instances when the Sensex declined, it was mainly due to domestic reasons. It's during these moments that diversification will demonstrate its worth by providing some degree of downside protection.

When we take the quantum of the market fall, during the same timeframe, the Sensex fell by more than 3 per cent on 24 separate occasions. Out of these, the S&P 500 also had significant drops of over 3 per cent 12 times. This statistic suggests that the S&P 500 did not always move in lockstep with the Sensex during these downturns.

The reason behind this
Markets, while globally connected, can display intriguing divergences due to varying local circumstances and policies. While asset classes might not vary, the economic landscape of each country certainly does. Different countries have unique economic policies, industrial growth rates, geopolitical scenarios, and many other macro and micro variables.

For instance, while the US might be grappling with an interest rate decision by the Federal Reserve, India might be uplifted by an optimistic monsoon forecast that promises strong agricultural output. Such nuances can still drive market performance in different ways.

Why diversification still matters
Needless to say, during all these times, if a part of the portfolio had been invested in the S&P 500 or any other international index, say Nasdaq 100, with similar traits, the total investment value would have fallen less than what it would have if entirely invested in domestic equities.

For example, if you invested Rs 1 lakh in the HDFC Index Fund (S&P BSE Sensex Plan), which tracks Sensex, since May 2020, your investment would have grown to Rs 1.96 lakh as of October 31, 2023. Sounds good, right?

Now, let's examine a diversified approach. If you invested the same amount but allocated 70 per cent of your investment to the HDFC Index Fund and the remaining 30 per cent to the Motilal Oswal S&P 500 Index Fund (which tracks the S&P 500 Index), your investment would stand at Rs 1.85 lakh as of the same date.

But there's more to this narrative. In the very month of May 2020 itself, Sensex took a steep dive, and the HDFC fund, mirroring this index, fell by -3.78 per cent, making your investment lose value by Rs 3,776. But the diversified portfolio only dropped by -1.46 per cent, reducing your losses to just Rs 1,464.

This is not a one-time thing; during four out of six such worst falls, the diversified portfolio does better.

This exemplifies that while the end return difference might appear slightly less, a diversified portfolio would likely offer a smoother ride with reduced volatility, especially during downturns while also protecting your money if it was all in one place.

Conclusion
International diversification is effective.

By diversifying internationally, you're not merely spreading assets across similar equities but also different economic narratives and unique local factors that can influence market behaviour.

While global events can temporarily tie markets together, local factors often pull them apart, creating opportunities for risk reduction and potentially better returns.

Also read: The DIY route to international investing