The big problem with investing overseas is that the major international markets are highly correlated, which means that if the UK market falls you are highly likely to lose on your overseas equities too. For example, since 1987 the correlation between annual changes in MSCI's UK equity index and in the US or euro markets has been 0.84 in sterling terms, which suggests the three markets move almost in lockstep. The correlation between the UK and MSCI's emerging markets index has been lower, but has still been a hefty 0.55. If anything, these numbers understate future co-movements, because correlations between markets have been rising over time.
Don't we get better returns from investing overseas? Not necessarily. The most promising main candidate here is emerging markets. Since 1987, MSCI's index of them has risen 9 per cent per year in sterling terms, compared with just 5 per cent for UK equities. Much of this extra return, however, has been a reward for taking on risk. The Sharpe ratio on MSCI's emerging markets index (annualised returns divided by annualised volatility) has been only slightly higher than that on the UK market, at 0.37 against 0.35.
Another way of looking at this is to consider emerging markets' alpha - the portion of their returns which can't be explained by their correlation with the UK. Since 1987, this alpha has been 0.48 percentage points per month, implying that emerging markets would give an annualised return of 6 per cent if the UK market were flat. This might sound respectable. But we can't rule out the possibility that it has been merely because emerging markets investors got lucky. If true returns on emerging markets were the same as those on UK equities, there's a one-in-nine chance that we'd get an annualised alpha of 6 per cent simply by chance in volatile data. And, of course, even if returns have been genuinely good in the past, there's no guarantee at all that they will remain so.
The numbers, then, don't seem to justify overseas investing. Nevertheless, there are three arguments for doing so.
One arises from the case for investing in trackers. This is that you know no more than the average investor and so should invest like the average investor. But, of course, the average investor around the world holds a portfolio of global equities, not just UK ones. Holding more UK shares than their weight in the global equity market would justify - around 7 per cent - amounts to betting that the UK will offer better risk-adjusted returns than the average global investor expects. This is a strong view. And passive investors - by definition - don't want to take strong views.
A second case for international diversification is that it can protect us from a fall in the pound. Such an event would hurt many of us - especially those on fixed incomes such as holders of flat-rate annuities - simply because it would raise import prices and the cost of living. It would hit even harder those of you hoping to buy a holiday home overseas, because your pounds won't buy as much. Holding overseas equities is a hedge against these risks, to the extent that the sterling value of overseas shares would rise if sterling falls.
However, this hedge is very imperfect for eurozone shares; since 1987, the correlation between annual changes in the euro/sterling rate and in the returns on eurozone shares relative to the UK (in sterling terms) has been only 0.21. This means that euro shares often don't outperform the UK if sterling falls. For example, sterling fell a lot in 2008-09, but euro shares didn't much beat the UK in sterling terms.
Things are, however, better in the US; the correlation between annual changes in the dollar/sterling rate and in relative performance of the two equity markets (in sterling terms) has been a hefty 0.68. This implies that US stocks, rather than European ones, might protect us from a weak pound.
A third case for investing overseas is that doing so protects us from very nasty danger - that the UK could suffer years of economic stagnation and low equity returns, as Japan did in the 1990s. I say this is a nasty danger because it would also condemn most of us to low wage growth and job insecurity, too. For investors with years of labour income ahead of them, a big position in UK equities amounts to putting all their eggs into the same basket - the UK economy. This is obviously risky. Investing overseas protects us from this.
Of course, this only works if we invest in markets that avoid stagnation. Given that the eurozone is at least as likely to suffer this fate as the UK - and might even infect the UK - it is no case for holding European stocks. Nor is it a cast-iron case for investing in the US; when former US Treasury secretary Larry Summers popularised the term "secular stagnation" he had the US in mind. It might, however, be a case for investing in emerging markets. In aggregate these, for all their other faults, are less vulnerable than mature economies to going ex-growth. (Some are vulnerable to the middle-income trap - but that's a separate risk!)
It might be, therefore, that the best case for investing in emerging markets isn't so much that they have merits of their own, but rather that they lack the possible defects of developed markets.
