Reduce Portfolio Risk Through Global Diversification.

While the U.S. stock market has performed superbly in recent years, 2000 has been a year of flux -- making it a good time to revisit the argument that allocating investment dollars to overseas markets is prudent.

As domestic markets continue their seemingly aimless meandering, where do investors look for fresh equity growth? Perhaps the Old Continent holds some new opportunities. Certainly the U.S. stock market seems to be struggling. Even with the Nasdaq market rebounding from its ugly spring slide, the fabulous returns of recent years aren't likely to reappear.

The current U.S. economic cycle is now approaching its ninth year. How much longer can it continue? Domestic equity markets appear to be fully valued, given the elevated price/earnings ratios of the cap-weighted S&P 500 Index. If they haven't done so already, CFOs and their investment managers should be thinking about rotating funds into other sectors.

Meanwhile, one index that has been overlooked by some investors due to lagging performance in recent years is the EAFE (Europe, Australasia and the Far East). The EAFE has lately accelerated -- and in fact, topped the S&P 500 in 1999 (27% to 21% average returns) for the first time in several years. It now seems likely that the EAFE will outperform the S&P 500 for at least the first three to five years of this century.

Between 1994 and 1998, the average annual return of the EAFE index was about 10%, which lagged behind the S&P 500's 23%. But during the 1980s, the EAFE outperformed the S&P by an average of 5.5% per year (+21.8% to +16.3%). The cyclical nature of the relationship between these two indices is apparent.

Based on quantitative valuation measurements done by our organization, which include price/earnings, price/book ratios, return on equity, and earnings growth rates, we have concluded that the developed international (EAFE index) markets are currently undervalued compared to the S&P 500.

Converging Market Forces

One of the underlying factors of the equity performance shift has been the unification of the European economies, which has triggered a movement towards American-style capitalism. The main catalyst has been increasing economic deregulation, leading Europe into a free market which increasingly resembles that of the U.S.

Europe has created a free flow of people, capital, goods and services within its collective borders. The elimination of tariffs and non-tariff barriers indicates that Europe's old defense mechanisms are slowly dissipating. This portends well for European economies, as well for as the equity offerings of quality companies on the continent.

Merging Europe's economies under a uniform currency has brought interest rates down to a relatively low level for all the member countries, leveling the cost of capital. At the same time, converging inflation rates are making real interest rates equal to all.

By unifying, European governments have let the Germans, with their conservative economic policies, set the tone. This has created an integrated union that has enabled the weaker governments to find the strength to put their fiscal houses in order. It's a ploy that is working marvelously, with positive ramifications for business. Companies headquartered in the areas suffering from chronic inflation in the past are benefiting from lower interest rates.

The cost of capital in Italy or Spain, for example, has historically been much higher than that of post-war Germany. Italy and Spain have had to deal with the burden of paying extremely high nominal interest rates, which reflected high inflation rates and included a larger risk premium, resulting in an elevated real, as well as nominal, cost of capital. Today, with the Euro, the playing field is level.

The U.S. economy, on the other hand, seems close to full maturity. Domestic support for the U.S. bull market has come from the "Goldilocks" environment: Stable economic growth, subdued inflation, declining interest rates (at least until recently) and rising earnings. An immense investment by Baby Boomers in mutual funds and retirement plans has fueled the unprecedented valuations in the U.S. However, the impact of the Baby Boomers will soon begin to abate.

As the collective impact of these events becomes more apparent, institutional investors, in particular, are beginning to diversify their portfolios away from the U.S. and into international equities. Early participants in this momentum shift will likely be rewarded with the greatest long-term performance.

Entrenched Attitude

While the whole concept of global investing is more widely embraced today than it was a decade ago, there is still a lot of resistance. It's not unusual, even today, to encounter financial executives and institutional investors who consider all international equities as inherently risky. Their perception is that all international stocks possess the same risk/reward characteristics, a misconception that prevents them from exploring international diversification.

Then too, the spectacular performance of the U.S. equity markets over the past eight years has many investors hesitant to leave the domestic market, hoping there is still more to come. Some question the logic of moving funds out of what they perceive as an endless run of 20% or better annual returns from domestic stocks. Of course, much of their enthusiasm for domestic equities is based on the performance of indices like the S&P 500.

But Dick Vartadanian, chief investment strategist at New York's Republic National Bank, suggests that when comparing the EAFE and the S&P 500, it's important to recognize that the two are measured differently. "Investors who look only at the indices might get a distorted picture," says Vartadanian. "There is a significant difference between the performance of a market index and that of a typical stock. That difference makes it easy for investors to be thrown off."

The performance concentration of the S&P 500 is among the top 25-40 stocks, referred to as the "two-tier effect." Performance may broaden from time to time, but fundamentally it remains concentrated among the largest issues, while the performance of the EAFE more closely reflects the market as a whole. So when comparing the EAFE and S&P 500 indices for 1999, the EAFE performance edge, 27.11% to 21.04%, was actually better than it appeared because of the significant difference in measuring the indices. And the Dow Jones Asia/Pacific Index has consistently outperformed its U.S. and Europe counterparts since mid-1999.

While experienced financial executives understand that financial markets are cyclical and that the current boom in the domestic market will end, the majority of today's investors were not in the market in 1987, the last time the bottom dropped out. As a group, these investors are more comfortable waiting for unmistakable signs that the feast has ended before shifting their assets into other areas, such as European equities. It's a herd mentality that could prove costly.

There are other economic considerations that support the case for global portfolio diversification. Ninety-four percent of the world's population resides outside the U.S. Consider China, with over a billion people, $150 billion in hard reserves and 7%-8% annual growth. China is expected to represent 25% of the world GDP by the year 2025.

Non-U.S. markets now account for about half of the total world market capitalization. Recent trends suggest that their share of this aggregate capitalization is likely to grow. Just the immense size of these markets suggests that investors who shun them could miss out on lucrative opportunities. Consider that 9 of the world's 10 largest real estate companies are based overseas, as are 8 of the 10 largest automobile, insurance, metals and gas & electric companies, and 7 of the 10 largest banking and beverage companies. Does it make sense to overlook them?

The Pros and Cons of ADRs

While a portfolio of U.S. multinational companies can deliver economic diversification, it will not provide capital markets diversification the way a portfolio composed of American Depository Receipts (ADRs) can. ADRs are negotiable certificates issued by a United States Depository bank, such as Bank of New York or Citibank, which represent shares of non-U.S. companies. Each ADR represents one or more ordinary shares on deposit at the bank.

ADRs offer some worthwhile benefits when compared with ordinary shares, but are not without disadvantages. While they provide both economic and portfolio diversification, some individual sectors or foreign countries may lack a sufficient number of ADRs to provide the desired level of diversification. The number of available ADRs has risen dramatically from the 300-500 issues listed just a few years ago, but not every investor will be able to find adequate diversification in all areas of interest.

Similar to U.S. securities, ADR annual reports are, for the most part, in English. Transactions settle in three business days and are quoted in and pay dividends on the underlying shares in U.S. dollars (the issuing bank does the conversion). But ADRs are issued primarily by large or rapidly growing companies, so those seeking investment in mid- or small-cap sectors have limited choices.

ADRs avoid global custody charges associated with holding foreign shares and are more easily registered and delivered to investors than ordinary shares. ADRs are often marginable, while ordinary shares are not. ADRs are also convertible into the underlying security at the investor's request. There is a presumption among some that it is cheaper to buy securities in a local currency than to convert to U.S. dollars, but this belief has been largely disproved. Nonetheless, the costs of trading ADRs can, at times, be a bit more expensive in certain countries such as the United Kingdom.

Finally, while ADRs facilitate proxy voting and often have listed options, the volume of some exchange-listed and Nasdaq-traded ADRs indicates there is less liquidity in the issues on an ADR-to ADR trading basis. As such, trading in the home market and converting to/from ADRs with a modest increase in cost may be required.

But whether spending for ADRs or non-U.S. issues in general, the old rules about diversification generally apply. Putting all, or nearly all, your eggs into one basket is risky, no matter how well that basket has been performing. Globalization, with its movement of capital into underrepresented and fastgrowing markets, is here to stay, and investment officers should think about spreading their bets to lower their risks.

Robert A Simms is Chairman and CEO of Simms Capital Management Inc. in Greenwich, Conn., a privately held, registered investment advisor founded in 1984.