Expanding an investment portfolio with international allocations gives investors access to a broader range of opportunities, with flexibility to focus on different regions. Ways to diversify include adding an allocation to a specific country or using both region- and country-specific funds to develop an appropriate allocation tailored to investors' individual needs. In our view, closed-end funds offer a compelling, professionally managed avenue toward international diversification.
A world of choices
We live in a world of unprecedented choice. Anyone who has spent a Friday night trying to select a movie to watch, bouncing from streaming app to app, for the length of what could have been a film in itself can attest. Investment options are no different. While investors may have seen just a few readily available opportunities to diversify internationally 40 years ago, there are now thousands of ways to achieve this objective in a portfolio.
However, many investors, blinded by home bias, fail to recognize the potential benefits of investing outside of their own country. For instance, although the US represents less than 50% of the overall global market capitalization, US investors allocate 75% of their equity assets domestically.1 Home country bias among US investors is not surprising given the strength of US economy, currency, and stability of government. Yet, succumbing to home bias can mean missing out of a wider range of investment opportunities and the potential for strong returns.
What we mean by diversification
Diversification is more than just making a wide variety of investment choices. According to modern portfolio theory (MPT), diversification may help mitigate the risk of investment loss, to a certain extent, if allocations are made to asset classes with low correlations to one another.
Correlations are measured in a range from -1.0 to 1.0. A correlation of 1.0 means that two asset classes move in lockstep with one another, whether they go up or down. If two asset classes have a correlation of -1.0, they move in opposite directions proportionally. A correlation of zero means that the relationship between the movements of the two asset classes cannot be predicted. So, if one asset class has negative performance, another asset class with low correlation wouldn’t have equally negative performance. If there is negative correlation between the two, as one experiences negative performance, the other would generate positive returns. MPT suggests that enhancing portfolio with a mix of asset classes with low, negative or no correlation to one another may help increase risk-adjusted returns.2
Different countries have different correlations to one another, so diversifying among a variety of regions may benefit investment portfolios. Foreign investment doesn’t just expand the investment universe. It also unveils a world of investment opportunities with low correlations to one another (Table 1).
Table 1. Illustrating different countries' differing correlations to one another
Source: Morningstar Direct, as of 30 June 2023.
You can never go home again
While investors from any country can be subject to home bias, US investors, in particular, may have reservations about investing elsewhere. After all, the US is one of the most diverse markets in the world, has experienced moderate economic growth, and its equity market comprises the single-largest percentage of the global equity market.3 But, investing in only one country – even a large one like the US – can still be limiting.
Each region has a different concentration to certain sectors of the global equity market (Chart 1). Choosing not to invest internationally can mean missing out on some of the current and future leaders in various industries.
Chart 1. Regions having different concentration to certain sectors of the global equity market
Chart 2. Economic growth in China, India, and the US
Source: FACTSET, as of 30 June 2023. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.
Finding a good value
Buy low, sell high is a common investment maxim. Valuations can help determine whether an asset class or region is relatively expensive or cheap within the current market environment. Because of its strong stock market performance over the past several years, even in spite of the pandemic-induced market sell-off in early 2020, the US equity market looks expensive relative to other areas of the world (Table 2). Diversifying into less expensive regions may help investors reach their return objectives.
Table 2. Valuations for the US equity market have become more expensive
Source: FACTSET, as of 30 June 2023.
Seeking income? Dividends make a difference.
Studies show that dividend-paying stocks have historically outperformed non-dividend-paying peers. Currently, the US lags many other regions in terms of dividend yield (Chart 3). Dividends can make a significant difference. Higher dividends may generate stronger compound returns, which could help investments grow more quickly over time. Choosing to diversify among international stocks may present investors an opportunity to generate income and potentially achieve greater returns.
Chart 3. Dividend yields across various regions
Source: FACTSET, as of 30 June 2023. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
A shortage of psychics
We can't predict the next geopolitical hotspot or the next international success story, which is, in our view, all the more reason to consider diversifying with international investments. Chart 4 (below) illustrates the medium- and long-term performance of various regions. The top performers and underperformers change all the time. By investing in a broad range of industries and locales, provides a better chance of capitalizing on the most attractive opportunities worldwide.
Chart 4. Trailing performance of domestic and international equities
Source: Morningstar Direct, as of 30 June 2023. For illustrative purposes only. Past performance is not indicative of future results. Performance of the indexes above is not necessarily indicative of the performance of any ASI product.
Open possibilities with closed-end funds
Closed-end funds (CEF) may offer a compelling means to efficient international exposure. The most basic difference between CEFs and traditional, open-end funds is the number of shares the funds hold. CEFs issue a set amount of shares upon inception, unlike mutual funds, which can issue an unlimited number of shares over time.
This core difference impacts how CEF managers operate. Because CEFs have a fixed number of shares, there is a fixed pool of capital. Therefore, the market doesn’t force the buying and selling of closed-end fund shares as it does with open-end funds. For example, if markets start dipping, anxious investors are likely to begin pulling their money out of the equity market. This could force open-end fund managers to sell in order to raise the cash for the redemptions. They must meet this obligation whether they think selling is in the best interest of the portfolio or not. In the same scenario, closed-end fund managers would be more capable of staying the course since their capital pool is fixed. This holds true even when CEF investors make redemptions.
With this fixed pool of capital, CEF managers are able to remain fully invested, potentially in less liquid markets, through market cycles. And because of their unique structure, CEFs are suitable for high-conviction, long-term international investment strategies because they’re able to ride out short-term market dislocations.
Another important difference between CEFs and open-end funds is how they trade. Because a limited numbers of CEF shares are issued at inception, thereafter, they trade on the secondary market. This means investors can purchase shares at a discount, which may be advantageous. Of course, there is another side of the coin, too. Investors may also purchase CEF shares at a premium, which could be disadvantageous. It’s not as simple as this, however. Even if investors purchase closed-end fund shares at a discount, it’s possible that, over time, this discount could widen. Conversely, while investors who have purchased closed-end fund shares at a premium seem to be at a disadvantage, there is always the possibility that the premium could rise over time.
Discounts and premiums, which vary throughout the year (Chart 5), reflect a combination of supply and demand, performance and yield. Supply and demand govern secondary market prices. While over the long term, performance should be the most important factor, in the short term, investors have the opportunity to search for good funds trading at a discount.
Chart 5. Average monthly premiums and discounts for CEF peer group
Source: Morningstar Direct, as of 30 June 2023. For illustrative purposes only. Peer group is Morningstar US Closed-End Funds. Data definition: The monthly premium/discount from its NAV at the closing price.
While CEFs can help investors manage risk, changes in exchange rates and other factors may affect the investments. As such, investors may want to consider using CEFs as a component of a larger portfolio that is broadly diversified.
There are other important considerations investors ought to consider before choosing to diversify internationally with CEFs. Because CEFs trade on stock exchanges, there must be both a buyer and seller for a trade to occur, which may make it more challenging to buy or sell in certain market environments. Investors must consider personal objectives, time horizon and risk tolerance when constructing their portfolios.
Why international diversification?
It's easy to succumb to home bias and overlook the opportunities that international investing can present. But diversifying with international investments can benefit portfolios over the long term. Investing beyond one's own borders opens investors up to not only a wider range of investment opportunities, but also the potential for greater returns with lower overall portfolio volatility.
Why closed-end funds?
CEFs can help long-term investors achieve greater diversification while gaining the benefits of an actively managed approach. Investors could diversify by adding an allocation to a specific country or using both region- and country-specific funds to develop an allocation that suits their individual needs. Ultimately, there is a world of possibilities when diversification is unbound and few limits to the possibilities that are available when investors are free invest across the globe.
1 Charles Schwab, Macrobond, World Federation of Exchanges, IMF, World Bank as of 10 February 2022.
2 Investopedia, “Correlation and Modern Portfolio Theory,” February 24, 2020.
3 World Bank, 2018. Most recent data available.
Diversification does not ensure a profit or protect against a loss in a declining market.
Dividends are not guaranteed and a company’s future ability to pay dividends may be limited.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI” Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com).
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund’s investment return and principal value will fluctuate so that an investor’s shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund’s portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.
Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds’ market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds and mutual funds charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund’s gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. Both vehicles seek to deliver returns based on their investment objectives, but neither is FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Standard Investments does not provide tax or legal advice; please consult your tax and/or legal advisor.