Diversification is an important part of your investment portfolio. It ensures that risk is being properly managed by having exposure to multiple asset classes across different industries, geographies, and international economies.
It’s important to consider exposure to parts of the world that are outside of your domestic “market”, both where you live and where you primarily invest. This additional exposure is part of the diversity picture when reviewing your investment portfolio with your financial advisor (or by yourself if you’re a self directed portfolio crazy person like me). The world is continually changing and evolving, and what was once a strong growth sector or economy may look very differently in the future. Similar to a common behavioral economics pitfall, past performance is not indicative of future performance. For example, just because the US had the world’s largest GDP in 2020 and has held this title multiple times over the last 10 years doesn’t mean it will continue to do so over the next 20 (and it won’t thanks to China). Just because high flying growth tech names have led the recent years of the last bull run doesn’t mean it will for the newest bull run here that started after the March 2020 crash (and this is proving to be true with “value” oriented stocks leading the charge so far).
The two easiest ways to diversify is to differentiate between emerging or developing economies, and developed or industrialized economies. Although there isn’t a fixed threshold for what constitutes as developed versus developing countries, BDC.ca defines a developed country as having a,
“…mature and sophisticated economy, usually measured by gross domestic product (GDP) and/or average income per resident. Developed countries have advanced technological infrastructure and have diverse industrial and service sectors. Their citizens typically enjoy access to quality health care and higher education.”
Investopedia provides more context on the differentiation between developed and developing countries by stating the following characteristics:
Developed countries are more industrialized
Developed countries have stable birth and death rates due to higher quality medical care and standard of living
Developed countries have more women in the workforce, especially in management and executive positions
Developed countries use a lot more natural resources due to better access to technologies that use or require the usage of such resources
Developed countries have higher levels of debt due to easier access to credit facilities because of higher credit ratings
The United Nations has created an index called the Human Development Index, or HDI, that assigns a relative score for each country based on social and economic development. Factors that are considered in this index include access to education, life expectancy, and income, which are all measured on a relative scale between 0 and 1.
So how exactly would one go about diversifying their portfolio and getting exposure outside of their domestic country? The easiest way to do this as an individual investor is through Exchange Traded Funds (ETFs). There are a number of ETFs that retail investors (you and me) have access to that are traded both on Canadian and US exchanges. These ETFs offer investors exposure to different national economies around the world, as well as different sectors, foreign exchange rates, real estate investment trusts (REITs), fixed income (bonds issued from different countries and companies around the world), or companies from around the world that are lumped into categories that are factor based (i.e. growth, value, dividend paying).
ETFs also exist that are specific to one country’s market index, or consist of a group of country indices that share a similar geographic location (this could even be characterized as a continent exposure ETF, such as an “Asia” ETF). I’ve included a list of some of the most frequently traded and largest Vanguard ETFs measured by market cap below that offer international exposure (I am biased towards Vanguard because it is my favorite ETF provider since they offer low management fees):
In addition to ETFs, there are also opportunities to own companies that are domiciled outside of your domestic country. There are companies that are dual listed on multiple exchanges. It’s common to see a company listed both on a Canadian and US exchange, or on indices that are part of the same continent. For companies that are listed in one country but are not listed in a foreign index because of trading regulations or other domestic/foreign laws, they are sometimes listed in a foreign market via a depository receipt, or DR, instead. DRs are issued by a bank to represent shares in a foreign company that trade on a local exchange. This gives local investors the ability to invest and own shares of a company traded in a foreign market without actually having to access and trade in that foreign market. This is common for companies that trade on Asian markets that will have an American Depository Receipt, or ADR (a DR that trades on the US markets). There are over 400 ADRs that currently trade on US exchanges, which include commonly known companies like Alibaba, Sony, Unilever, Anheuser-Busch, Tata Motors, Toyota, and Novartis. There are also global DRs and International DRs which typically trade on European exchanges like the London Stock Exchange.
Diversification is all about managing risk. Risk always exists with investing, and it’s important to minimize risk and spread it out across the assets that you own, whether it’s with stocks, bonds, your house, or any other assets you have. If not managed properly, you could be exposing yourself to high potential losses sometime in the future due to a black swan event, market downturn, inflation, or volatile market prices. Having exposure outside your domicile ensures that you are always participating in the growth of economies external from the one you reside in, especially if the domestic market is small compared to other indices around the world. Markets around the world also experience economic cycles at different times than one another, which is key in participating in all bull markets around the world over a long period of time.
In today’s day and age, almost every publicly traded company has some international facet of their business, but owning these companies alone within your domestic market may not be enough to have adequate international exposure. While it’s important to focus on where you are invested domestically in familiar territory, don’t forget about the world that exists outside of your own backyard.