Current Debate Over International Equity Exposure Mirrors That Over Smallcaps in the 1990s, Says Russell Consultant.

Business Editors

TACOMA, Wash.--(BUSINESS WIRE)--Feb. 25, 2002

Analysts' recent call for investors to reduce exposure to international stocks is reminiscent of a similar scenario with small-cap stocks four years ago, says a Russell consultant.

Several prominent analysts recently have advised clients to decrease allocations to international equities due to a higher correlation of performance with U.S. stocks. They argue that a closer match in performance patterns reduces the diversification benefit of owning both asset classes. But a Russell consultant urges investors not to sacrifice future diversification just because current correlations between U.S. and non-U.S. stocks are higher.

"This is a case of deja vu," said Robin Penfold, a Russell consultant. "Today's discussion about non-US equities versus their U.S. equivalents mimics the 1990s debate between large-cap and small-cap stocks. In both cases, the answer should be the same: Both asset classes belong in a well-diversified equity portfolio."

Guided by past performance patterns, many investors in the late 1990s felt it was unnecessary and even unwise to invest in U.S. small-cap securities. The real gains, they concluded, were to be found in large-cap stocks. Much of their reasoning was based on the previous five years of strong outperformance by largecaps. But those who moved out -- and stayed out -- of smallcaps in the late 1990s missed the significant out-performance of these stocks over their large-cap counterparts during 2000 and 2001.

Penfold added that chasing high returns can result in disappointments. For example, international equity outperformed domestic equity by 20.5 percent a year in the five years that ended in 1988. Those that chased this high performance by foreign stocks were disappointed when, over the following five years, foreign equity under-performed its domestic counterpart by 12.2 percent.

Today many investors are chasing the relatively high performance of domestic equities, which out-performed their non-U.S. equivalents by 9.5 percent over the five years ending in 2001.

"They face being disappointed just like the investors who chased the higher performance of large-cap U.S. equity in the 1990s," Penfold said. "The conclusion: Don't let chasing high returns prevent you from diversifying your portfolio."

Penfold also finds another common strand in the debates on foreign and small-cap stocks. That is, the often specious nature of correlations.

This is timely. Recent observations show the correlation between domestic and international stocks is now hovering between 0.7 and 0.8. This correlation is high since the highest possible correlation is 1.0. A recent paper by three Yale University professors, for example, found that the correlation among international equity markets is near its highest point in 150 years.

"We could observe that current diversification opportunities are low," Penfold said. "Even were that true, however, diversification benefits can still be material with this level of correlation -- especially in the case of volatile assets such as equities."

He added that all this risks the "tail wagging the dog."

"We may be forcing our thinking to fit the input requirements of a spreadsheet model (the modern-day equivalent of forcing a square peg into a round hole)," he said. "Another option would be to consider what the high correlation implies. The implication is not that diversification benefits are slim but that markets are becoming more integrated."

To Penfold, this brings the discussion back to the experience of small and large stocks. The correlation between these is also in the range of 0.7 to 0.8.

"Does that figure mean we should stop holding small-cap stocks? No," Penfold said. "We believe that fiduciaries have been right to take a different view."

He added that although the correlation between large and small U.S. stocks has been high, fiduciaries have remained invested in the broad market. They have sought the broadest range of investments for their funds, and have not based their decisions solely on their models' interpretation of a high correlation.

"A similar logic should also apply to domestic and foreign stocks," Penfold said. "In other words, if the present high correlation (and only the high correlation) leads you to question your investment in foreign equity, shouldn't you also question your investment in smallcaps? I would reply `no' -- on both counts."

Frank Russell Company, a global investment services firm, provides multi-manager investment products and services in more than 35 countries. Russell manages $69 billion in assets and advises clients worldwide representing $1.8 trillion. Founded in 1936, Russell is a subsidiary of Northwestern Mutual and is headquartered in Tacoma, Wash., with additional offices in New York, Toronto, London, Paris, Singapore, Sydney, Auckland and Tokyo. For more information, go to www.russell.com.

Frank Russell Company, a Washington, USA corporation, operates through subsidiaries worldwide. International markets entail different risks than those typically associated with domestic markets, including currency fluctuations, political and economic instability, accounting changes, and foreign taxation. Diversification does not assure a profit or guarantee against loss in declining markets. Past performance is not indicative of future results.