Another take on global diversification

In my previous blog, I identified three ways to diversify globally – diversify by market size, naively, or use historical data to ‘optimise’ recognising that there’s no consensus  on which historical data to use (one hundred years of history or the past five years, annual or daily data, real or nominal returns….?)

The problem is even greater than how to decide how much to invest in each country.  There are two additional issues to address when diversifying globally.

First of all, should you have a currency view when you invest overseas?  Many fund managers offer products hedged into sterling.  Why?  Surely the point is to diversify currency risk as well as equity risk?  Or is currency a separate asset class?  In that case, the investor hedges currency risk and runs a separate portfolio with just currency exposure.  Unfortunately, there’s no academic agreement on which of these is the right approach.  But individual investors typically take the currency risk of investing overseas – or even in the FTSE100  – without realising what exposure they are taking on.  Many could not say whether their funds are hedged into sterling or not.

Second, when buying international funds, investors have a choice.  They can buy funds which have a mixture of bonds and equities, or they can buy specialist equity or bond funds.  Research shows that, of the three investment strategies I outlined above, the retail investor favourite is the naive approach – equal amounts in each fund.  And, as GestaltU argues in his blog, since there are more equity funds than bond funds out there, and more equities than bonds in so-called balanced funds, the naive approach leads inexorably to a heavy equity bias.  That may be a good solution for many investors, but it may not.

International investment is not for the faint of heart.

 

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