Should Investors Rethink Global Diversification Amid Tariff Uncertainty?

Diversification is touted as the only free lunch in investing, and so it goes that geographical diversification should benefit investors. Yet in the past several decades, international stocks have not rewarded anyone for their patience.

Their performance this year has been a rare bright spot, as they escaped the volatility that plagued US stocks in February and March. But the recent bout of tariff uncertainties is throwing both developed- and emerging-markets stocks for another loop. Could there still be a case for international diversification?

This Time Won’t Be Different

If we’re only looking at the recent decades, the answer seems to be a definitive no. Even setting aside performance, international stocks’ diversification benefit seems to be fading. Their correlation to US equities has seemingly settled into a new high since the early 2000s, especially for developed markets.

But going further down memory lane, this hasn’t always been the case. The following exhibits display the rolling three-year correlation and excess returns of the MSCI EAFE, MSCI All World ex USA, and MSCI Emerging Markets indexes against the S&P 500.

International stocks’ correlation and excess returns relative to US equities move in cycle. While developed markets reacted more in lockstep with the US market now, compared with the 1970s or 1980s, the two still diverged. In stress markets such as the 2008 financial crisis, developed-markets stocks’ correlation decreased as they outpaced their US counterparts. The same goes for emerging-markets stocks. They outpaced US stocks for most of the 2000s and maintained a correlation of around 0.7, albeit with higher volatility.

Given US stocks’ persistent rise in recent years, it might have been easy to forget how home bias detracts from a portfolio’s diversification. But let’s not forget the US stock market started the 2000s with the dot-com bubble and ended it with the 2008 financial crisis. Investors betting on the stellar US stock performance from the ’90s to continue would have missed out on great companies elsewhere, plus conversion gains from a weak dollar. Many developed European economies also suffered, but a well-diversified portfolio would have sailed ahead with its stake in Chinese and South Korean stocks, for instance.

Even if history were to not repeat itself, domiciles are increasingly less relevant in today’s globalized world. The large companies driving today’s stock markets are multinational conglomerates with global business and revenues. A domestic-only portfolio would likely exclude American depositary receipt listings such as $500-billion Novo Nordisk NVO and $200-billion AstraZeneca AZN, both of which derive over half of their annual revenues from the US market. Some of the largest companies in the world, such as Samsung Electronics SMSN and Saudi Aramco 2222, don’t even offer ADRs or trade on any American exchanges. As with most international stocks, the easiest way for retail investors to access these companies would be via an exchange-traded fund or mutual fund that handles withholding taxes and other operational hassles for you.

Globalize Your Portfolio

Choosing an international stock fund can go one of three ways: Using a do-it-yourself solution with single-country or regional ETF(s), outsourcing the task to an active manager, or going with a broad passive index fund.

For the first approach, the cost of holding multiple single-country ETFs (which tend to be pricey) and trading in-and-out of them will be significant. Even if we can repeatedly make the right country or region bet, a narrower scope will bump up the portfolio’s volatility and requires a steadfast discipline to successfully harvest its benefit. Between the added sticker cost and additional time and effort involved, this method seems to be one of diminishing returns.

Finding good active managers isn’t impossible but can be tricky. Only a fourth of active funds in the foreign large-blend Morningstar Category managed to survive and beat their passive counterparts over the trailing 10 years ended 2023. While this is still better than their active domestic funds counterparts, the odds are hardly convincing. Investors can look to systematic strategies that limit manager discretion risk while still enjoy flexibility to add marginal improvements, such as Dimensional International Core Equity Market ETF DFAI, which has a Morningstar Medalist Rating of Gold. The fund leans toward value and small-cap names with higher upside potential, while its profitability tilt weeds out struggling companies.

Yet at 0.18% a year, the Dimensional ETF is still pricier than most of the broad-market index funds that capture international stocks, available at under 10 basis points annually. Market-cap-weighted ETFs such as Gold-rated Vanguard Total International Stock ETF VXUS or iShares MSCI ACWI ex US ETF ACWX pull in much of the investable universe outside the US at razor-thin expense ratios. What these funds lack in flexibility, they make up for with a broad scope that doesn’t miss out on rising winners.

While straightforward and inexpensive, this approach does lump together the whole international ex-US market. We’re implicitly letting market capitalization decide the divide between emerging- and developed-markets stocks. The allocation has stood at roughly 20% for emerging-markets stocks and 80% for developed-markets stocks in the past decade. This mix might represent where global investors are pouring their money, but is it optimal? Emerging-markets stocks offer more diversification benefits to a US stock portfolio, but they also come at the expense of more dramatic swings during stress markets.

The next exhibit explores the incremental benefits of amping up our emerging-markets allocation compared with a market-cap-weighted index, the MSCI All World ex USA Index. The test portfolios use MSCI EAFE and MSCI Emerging Markets indexes as underlying securities.

Upping the emerging-markets stake increased the volatility of the international stock sleeve but lowered its correlation to the US stock market. An 80% allocation to emerging markets brings correlation to the S&P 500 down to 0.78, at the expense of a 3-percentage-point increase in standard deviation of returns compared with the market-cap-weighted index.

A more reasonable alternative was around a 40% allocation to emerging-markets stocks within the international stock sleeve. The additional volatility didn’t detract significantly from risk-adjusted return compared with the MSCI All World ex USA Index but improves its correlation to the US market. The Sharpe ratio of the 60% developed/40% emerging portfolio trailed at most by 10 basis points from that of the MSCI All World ex USA Index on a rolling three-year basis, even during stress markets such as the 2015 oil price crisis. The maximum drawdown for this allocation was around 58.5% compared with 57.6% for the index during the 2008 financial crisis (the figure was 51% for the S&P 500, for comparison). Nonetheless, there’s no guarantee that history will repeat itself, and the history that we just looked at only started from the 2000s, given data availability. Given the level of idiosyncratic and geopolitical risks present in developing economies, investors shouldn’t view their diversification benefit in isolation.