Foreign Developed Market Equity

Real Foreign Equity Returns Under Different Conditions
Geometric Annual Returns for Decades, Quarterly Returns for Quarters

Across all six functional currency regions, the effect on returns of two key factors is clear. First, the substantial returns earned in Japan during the 1980s, and second, the substantial returns earned on U.S. dollar investments (due to both a rising equity market and appreciating currency) during the 1990s (which cushioned the dramatic fall in Japanese equity values). However, these factors also make clear two key points about investing in foreign equity markets.

Over the full 1971-2002 period, historical real arithmetic average annual returns, standard deviation, skewness and kurtosis were as follows:

Real Foreign Equity Returns 1971 to 2002

In terms of performance, you can see that the returns on foreign equity have been roughly in line with the returns on domestic equity, except in Australia (where foreign equity returns were 3.7% above domestic equity returns between 1971 and 2002) and the UK (where foreign equity returns were 2.2% below domestic returns). On the other hand, foreign equity returns have been less volatile in every region but the Eurozone and US, where foreign volatility was only .9% higher than domestic. Moreover, the distributions of foreign equity returns across our six currency regions have generally had slightly more attractive skewness and kurtosis characteristics than domestic equity (i.e., less of a negative tilt, and not-as-fat tails, which means fewer large downside surprises). Finally, across all six regions, the correlation of foreign equity returns with domestic equity returns has been attractive.

However, as we noted in the section on foreign bonds, these volatility and correlation figures for foreign equity are not constant over time. Unlike the case with foreign bonds, both the volatility and the correlation between domestic and foreign equity returns tend to increase following a negative economic shock. This means that at least some of the apparent diversification (risk reduction) benefit from investing in foreign equities is, practically, a statistical illusion, as it tends to disappear when it is needed most.

On the other hand, risk reduction isn't the only argument in favor of investing in foreign equities. There is also the matter of expanding your access to attractive investment opportunities by looking beyond your home region. This argument is particularly strong when the equity market in your home region is small relative to the total capitalization of developed country equity markets (e.g., Australia, Canada, and to a lesser extent the UK). In other words, not only may you be able to reduce your risk (somewhat) by investing in foreign equities, but you may also be able to increase your expected rate of return.

Of course, this raises the interesting issue of what future rate of return an investor should expect on foreign equities in developed markets.

Our starting point is the expected future real returns we estimated in the domestic equity section of this chapter. We then and then adjust them using each region's current relative weight in the FTSE World Index. Finally, we assume that current inflation differentials between countries (estimated from their nominal government bond yield curves in mid-October, 2003) will drive future exchange rate changes. This yields the following expected real returns (in local currency) on foreign equity (as of October, 2003):

We should also stress that, as in the case of all of our other estimates of future asset class returns, this one is also highly uncertain.

So, to sum up the arguments in favor and against investing in the foreign developed market equity asset class: