Going Offshore: Be Careful What You Wish For

Most of our big stocks are already global companies, which means you are likely already diversified. And if you still plan on increasing your offshore exposure, make sure you understand whether it’s the currency or the stock you’re investing in that makes it worthwhile.

- Roland Rousseau

This article tries to address one simple but important aspect of offshore diversification. In general, offshore investing is well-known to be beneficial in improving risk-adjusted returns. But is it the currency or the stocks that make offshore investing worthwhile?

Even US investors can benefit from offshore diversification despite having a broad and deep domestic equity market. Therefore, it should be even more true, in general, for our narrow and shallow market to broaden and diversify our equity exposures. However, as Clifford Asness et al (www.cfapubs.org in May/June 2011) clearly state, diversification is good in the long run but ‘lumpy’ in the near term.

“Critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns. Although true, this observation misses the big picture. Over longer horizons, underlying economic growth matters more than short-lived panics with respect to returns, and international diversification does an excellent job of protecting investors.”

As Graph 1 demonstrates, the three drivers of equity portfolio return deliver varying degrees of risk and return through time. For example, in 2001, the domestic FTSE/JSE Top 40 Index delivered about a 33% positive return. In addition, the currency (rand) depreciated by about 59% adding significant returns for anybody who held offshore exposure. The MSCI in 2001 lost about 18% in US-dollar terms which would have detracted from a global equity holding.

In 2001, the beneficial currency depreciation for offshore investors, coupled with the local equity market rally, dwarfed the loss of the MSCI World index. But here lies the important realisation from Graph 1.