Foreign-Stock Funds and the Benefits of International Diversification

In addition, many companies now are diversified internationally. Thus, Coca-Cola (KO Quote), though a U.S. company, will reflect the ups and downs of conditions overseas. These interdependencies can create a "contagion effect," Lewis says. "You have multinationals in all these markets. It's not the case that we are islands in ourselves. We really are more integrated."

Does that really mean international diversification no longer pays? "Let's look at how the benefits of international diversification for a U.S. portfolio holder might be declining over time," Lewis says, pointing to her research. She compared the ups and downs of U.S. stocks, represented by the S&P 500, with the movements of baskets of foreign stocks. Stocks that tend to move in step with one another have a high "covariance," while those moving in different directions have a low one.

"I found that the covariances among ... stock markets have indeed shifted over time for a majority of the countries," she states in her paper. "However, in contrast to the common perception that markets have become more integrated over time, the covariance between foreign markets and the U.S. market has increased only slightly from the beginning to the end of the last 20 years." In addition, she found that the foreign markets' volatility, or "standard deviation ," "has declined over this time."

Throwing ADRs Into the Mix

Foreign stocks at first appear less appealing in recent years because they are more likely to parallel the movements of U.S. stocks. But this diminishing benefit is more than offset by the fact that foreign stocks have become less risky, as is shown by their reduced volatility.

Thirty years ago, a U.S. investor could have reduced annual portfolio volatility by 30% by mixing in foreign stocks. Though the figure has fallen, it remains at a healthy 15%, Lewis found.

As a practical matter, not many U.S. investors would have held all the foreign stocks they would have needed to get the full benefit 30 years ago, since that would have required them to put 75% of their stock holdings into foreign issues. Today, an investor can get the full benefit by putting just 20% into foreign stocks, Lewis found.

To explore why U.S. investors still fall short of this allocation , Lewis looked at whether they may be getting the same benefit by investing in American Depositary Receipts , which are foreign-stock stand-ins traded in U.S. exchanges but not counted as foreign-stock holdings. Many U.S. investors are attracted to ADRs because these securities may meet accounting and reporting standards that are more stringent than those in many other countries.

Lewis found that ADRs tend to keep pace with U.S. stocks, so they provide less diversification benefit than do foreign stocks traded on foreign exchanges. She concluded that "the diversification properties of [ADRs] are inferior to investing in foreign markets directly." This also meant that adding a mix of ADRs and foreign stocks to a portfolio would not work as well as adding just foreign stocks.

Lewis emphasizes that her study did not look at whether foreign stocks offer better returns than U.S. stocks. Many investors who do like foreign stocks believe there are more bargains in markets that have undergone less scrutiny, and many think foreign economies, especially the emerging ones, have more room to grow than the U.S. economy does, offering the potential for greater stock-market gains. But even without these considerations, owning foreign stocks is still a good idea for U.S. investors, she says, because it helps reduce risk.

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