How International Investing Still Pays

In the U.S., smart investors could hedge their domestic investments by buying stocks or index funds from other countries. In years where the American market declined, that international exposure gave you uncorrelated performance from foreign markets, dampening some of your losses.

But over the last four decades, the world’s economies have become increasingly connected due to globalization and free trade. That has made international diversification harder, as countries’ markets tend to make similar moves up and down—particularly during major crises.

A new approach co-created by Robert Korajczyk, a Kellogg professor of finance, offers a better way to capture the international advantage. Using data from 27 countries from 1966 to 2022, Korajczyk and his colleagues found that a portfolio strategy combining stocks from the U.S. and another country consistently outperformed investing in the U.S. alone.

The secret, the authors found, was identifying the local factors that affect a foreign country’s economy apart from global forces that act on all countries. Pairing the stocks most exposed to those influences with U.S. investments captured the low-risk, high-reward magic of diversification better than merely investing in broader market indexes.

Impressively, the strategy retained its edge into the 21st century, when globalization started causing many economies to move in sync.

“Diversification still works, but it works better if you try to actually diversify as opposed to just buying a bunch of things that are all really heavily correlated with each other,” Korajczyk says.

Diversification vs. globalization

Financial advisors regularly advocate for diversification as a good path to reducing unnecessary risks. While concentrating a portfolio in a single stock, sector, or country can reap big rewards, it also carries heavy risk. As part of a steady, long-term approach, experts advise spreading funds out across investments that don’t move in tandem.

“When you diversify by holding more assets that aren’t perfectly correlated with each other, you’re able to reduce the risk of the portfolio without much of a sacrifice in returns,” says Korajczyk, Harry G. Guthmann Professor of Finance at the Kellogg School.

International investors accomplished this goal by buying stocks or index funds from different countries and assuming they’d perform independently. In a down year for U.S. companies, stocks from India, Japan, or Germany might be on the rise—and vice versa.

But today, U.S. stocks are more entwined with the global economy than ever. A company like Apple may be based in California and trade on the NASDAQ stock exchange, but its customer base and operations are spread around the entire world. And as the global economy has grown more connected, it’s become more susceptible to worldwide shocks, like the financial crisis of the 2000s or the Covid-19 pandemic.

Accordingly, just buying a collection of market indexes from around the world doesn’t provide the diversification benefits that it used to.

“What we find in the paper is that, if you just do a naive diversification where you buy some of everything, you don’t get all that much risk reduction,” Korajczyk says. “There’s some there, but it’s not huge.”

Finding the right targets

Korajczyk and colleagues Soohun Kim and Andreas Neuhierl, both PhD alumni of Kellogg’s Department of Finance, decided to take a more-finessed approach. They divided the economic factors that affect companies into two groups: common factors and country-specific factors.

Fluctuations in oil prices, for example, will ripple across all the world’s markets. But country-specific risks such as economic policies, labor laws, tax-code changes, or even weather can drive local stock performance independently of global events. A drought in Andalusia will hurt Spanish olive oil companies, while a new Brazilian trade agreement could boost the profits of the country’s coffee exporters.

The researchers built a model to identify these country-specific factors and to determine how sensitive companies are to their influence. Then they used that model to construct 26 different portfolios that paired U.S. investments with a selection of stocks from one foreign country.

“We’re looking at things like their earnings and other characteristics to estimate these factor exposures and to break them down into worldwide risk versus country-specific risk,” Korajczyk says. “So instead of just buying everything, we can buy a more-targeted portfolio.”

When the researchers analyzed the performance of these portfolios, most of them offered significantly higher risk-adjusted profits than U.S. stocks alone. Using the Sharpe ratio—a measure of investment returns relative to risk—they saw improvements as high as 400 percent.

“It’s a bigger effect than I expected,” Korajczyk says.

Local conditions still matter

That edge proved robust over the study’s entire sample, even as the world economy grew more connected. And the pairing strategy worked just as well for the U.S. and G7 partners Canada, France, Germany, Italy, Japan, and the United Kingdom. That suggests that even closely tied markets in a global economy continue to have local differences that can be leveraged by investors to diversify.

“The global factors are getting more important, but the country-specific factors haven’t gone away,” Korajczyk says.

Due to the amount of data and calculation required, it’s not a strategy designed for most retail investors. But Korajczyk could see an exchange-traded fund or mutual fund basing its strategy around the researchers’ country-specific-factors framework or a second approach that arbitrages gaps in how global risks are priced in different countries.

“Funds built on these strategies could offer the public a better-diversified portfolio than just buying some of everything,” Korajczyk says.