International Diversification

November 14, 2011

We recently attended the Dimensional Fund Advisors (DFA) Canadian Investment Conference. This conference was unlike those typically organized by mutual-fund companies, as a lot of the presentations were made by finance professors such as Eugene Fama (University of Chicago) and Ken French (University of Dartmouth), plus some younger talented academics. Ideas from these thinkers have been part of the curriculum at business schools for decades. Here are two important takeaways from these presentations:

  1. One hundred and eleven years of global equity-market data provides us with an estimated real return of 5.5% (net of inflation) on a global portfolio. Among the 19 countries reviewed, the highest return came from Australia, at 7.4%, and the lowest return came from Italy, at a skinny 2.0%. Such a broad range of returns highlights the unreasonable risk involved in investing in a single market: no one can predict which country will outperform and which will underperform. These results are depicted below: 
  2. According to a recent survey from Towers Watson, Canadian pension funds still have an important home bias in their investments: Canadian stocks represent on average 45% of their equity portfolio—10 times Canada’s weight in the global markets (4.7%). This bias toward domestic equities results in under-diversification. The presenter estimates that this type of portfolio is heavily concentrated in its 50 largest stock positions.

These research results advocate strongly in favor of international diversification. While the Canadian market has been among the best-performing stock markets worldwide in the last decade, there is no certainty that it will rank among the high performers going forward. While a certain degree of home bias may be appropriate (chiefly to reduce taxes), international diversification definitely helps to alleviate the risk of holding the “wrong” country market over long periods. This explains why PWL portfolios generally are far more internationally diversified than the average Canadian pension fund.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.