Global diversification – an Australian perspective
There is a post by Dennis P. Quinn Hans-Joachim Voth – good Finance professors both of them – on why international diversification does not seem to deliver the benefits that were expected. They argue that globalisation has made everything more correlated.
I think they are spectacularly wrong.
Obviously the good Professors are not Icelandic. Iceland really has almost totally melted down – and if you were Icelandic but have global assets you have done just fine thank you very much. In Kroner you might be up 500 percent even if your foreign assets were not that good. Having an even small percentage of your wealth diversified globally has saved your sorry and cold Icelandic backside…
I enjoy all those mathematical models that suggest that if it is correlated it is not diversified. But day-to-day correlation is not where it is at. What you really want is “uncorrelated in a crisis”. International diversification is pretty good at that. Iceland has had a crisis – but New Zealand for instance – a country often paired with Iceland looks OK for now.
Now I am going to give you an Australian perspective. Felix Salmon points us to a Merrill Lynch report that suggests on measures like current account deficit, short term funding requirements etc (all the things that obsess me) that Australia is the riskiest country in the world. Latvia obviously is not a country according to Merrill Lynch – but they are more or less right. Australia really is risky. It has an American style spending habit, a property boom that allows me to go to Sausalito and think the houses are inexpensive (they are compared to Bronte). And it has an economy highly dependent on a small number of commodity exports. (Iron ore and China looks like a risk to me.)
In other words Australia could do an Iceland. I don’t think it will – Australia has a few advantages which include a government that has fiscal credibility and very low debt levels, a banking system that is relatively small to GDP (at least compared to Iceland), and the minerals that China needs (and will need more of one day).
But Australia is not riskless. The risks whilst small are very real. And if you are a well-to-do Australian and you are not diversified at least 20 percent globally you are doing yourself no favours. Those with self-managed superannuation funds should pay heed.
If you are an Australian and you diversify globally but swap the currency back to Australian dollars (as one well known retail fund manager does) you are also failing to diversify. The main advantage of diversification internationally is that it removes the country specific catastrophe risk and swapping the currency back is simply insane. Indeed an Australian retail international fund that wants to swap all the currency back is putting marketing ahead of client asset protection and is – in my view – almost criminally negligent. Just think how an Icelandic international fund would look if it had swapped its currency exposure back to Kroner! They would be a wipe-out because they would have to sell their valuable international assets to meet their obligations to deliver valuable foreign currency for worthless Kroner.
But what is good for an Icelandic person or an Australian (some global diversification fully accepting currency risk) is good for an American too. The US is bigger and more stable than Iceland or even Australia – but it is not riskless. There remains a small chance that somehow the US will become a fascist dictatorship. The chance I suspect is smaller after last Tuesday – and might be vanishingly small anyway – but it is not zero. There are plenty of things that can go wrong.
And there is a small chance that the US could go to pot in ways that I can’t envisage. And in that case international positions would not be entirely correlated. The US might take some of Europe down with it – but China and Australia might be OK. A little international diversification would be great for Americans too.
The dear Professors have this wrong. International stocks are correlated but not entirely and not in extrema. Rich people in small Latin American countries know this. Maybe the good Professors should too.
John Hempton