William J. Bernstein
The fundamental advantage of international diversification is the fact that that the stock returns of different nations do not move in lock step, and yet over the long term seem to mean-revert. Rebalancing the world’s major regional indexes against each other on an annual basis earns the investor about 1% of excess annualized return. For example, for the 30-year period from 1970 to 1999 an annually rebalanced portfolio consisting of 50% S&P 500, 20% continental European, and 10% each UK, Pacific Rim, and Japanese stocks had a return of 14.53%, versus 13.64% for the unrebalanced portfolio.
In some cases slicing the global equity pie even thinner can result in yet higher excess returns. In a another article in this issue we show that rebalanacing emerging markets results in a several percent excess return.
What could be simpler? Simply hold equal (or unequal but fixed) amounts of various national markets, rebalance periodically, and collect a few hundred or so basis points of excess returns over your cap-weighted colleagues. (Note that "cap weighted" is synonymous with "unrebalanced.")
The obvious tool for accomplishing this is the World Equity Bench Security (WEBS). These exchange-traded-funds (EFTs), produced in cooperation with Barclays and Chase-Manhattan and traded on the AMEX are essentially closed-end securities indexed to 17 national markets. The pesky closed-end discount/premium problem is eliminated through a complex arbitrage mechanism.
One problem with WEBS is that with the exceptions of Mexico and Malaysia (whose trading suffers from the currency controls instituted by that country in 1998) they are all in developed markets, particularly European. And as we’ve already shown, the benefits of rebalancing European national markets is both small and chancy.
An even bigger problem is that not all indexers are created equal. From inception in 1996 to September 1999 WEBS have returned an average of 1.81% less than their benchmark national indexes on an annualized basis. This shortfall is known as "tracking error" (TE). How did this happen? For starters, the average expense ratio on these exotic birds is a whopping 1.32%. But even more impressive is the correlation between the TE and the fund turnover. I’ve tabulated, then graphed, this relationship below:
Tracking Error 3/96-9/99 (Annualized)
As you can see, there’s a pretty good relationship between the two; for each 14% of turnover 1% of return is lost (slope = -0.072). The t-stat/p-value for this is –3.44/0.0036, with an R-squared of 0.44. In other words, there can be no question that although you get badly nailed by these funds’ expense ratios, the high-turnover funds, like Belgium, are particularly treacherous.
The Vanguard experience with international regional indexing has been far more agreeable. The TE since inception in 1990 for the Pacific and European funds has been +0.12% and +0.32% respectively, even after the approximately 0.35% expenses of these funds. In short, the theoretical benefits of using WEBS is small and the real-world execution awful; you’re far better off going with Gus than putting on WEB feet.
What's curious about all this is that Barclays’ recent foray into domestic ETFs has everyone so rattled; even Vanguard has an eagle eye on their venture, and is considering ETFs of their own. But if the WEBS experience is any guide, Barclays (like the Dreyfus index group) is the Gang That Couldn’t Shoot Straight. They can't even seem to get the S&P 500 right; the Barclays 500 Index Fund lags Vanguard's by 32 bp per year since its 1993 inception despite a nearly identical expense ratio.
For this reason alone I’d be exceptionally cautious about using any of the Barclays’ new products. A prudent policy would be to keep an eye on their TEs over the next few years before jumping in.
Copyright © 2000, William J. Bernstein. All rights reserved.