Morningstar Advisor - February/March 2010 - 20

Investment Briefs The Reality Behind Global Risk-Diversification One of the reasons that advisors look at international investments for their clients’ portfolios is risk diversification. Historically, the risk-diversification benefits of international markets have come from their reasonably low correlation with the U.S. market. According to Morningstar’s research and communications manager Jim Licato, however, the correlation between the U.S. and international markets has increased significantly in recent years. What can investors expect going forward? The image illustrates the 60-month rolling correlation of U.S. stocks (represented by the S&P 500) to international stocks (represented by the MSCI EAFE Index). The graph shows the recent rise in the correlation between the two asset classes, suggesting that the benefit of diversification has suffered in recent years. The maximum benefit would have come in the 60-month period that ended in July 1987, when the cross-correlation was 0.26. On the other hand, the smallest diversification benefit would have come in the 60-month period that ended in October 2009, when the cross-correlation was 0.91. The monthly average over the entire time horizon was 0.60. 60-Month Rolling Correlation January 1970 to November 2009 S&P 500 vs. MSCI EAFE 1 0.8 0.6 0.4 0.2 76 80 84 88 92 96 00 04 08 risk (or that minimized expected risk for a given level of expected return). If one were to expand the set of assets in a portfolio to include international stocks, an improvement in the risk/return trade-off is apparent. The improvement in the risk/return trade-off is primarily a result of the rather low correlation between international stocks and U.S. stocks over a majority of the period analyzed. As a result, points on the global frontier offered higher returns per unit of risk than points on the domestic frontier. Although the diversification benefit and risk/return trade-off have suffered of late, recent trends may not be indicative of future performance. Efficient Frontiers with and without International Stocks January 1970 to November 2009 Domestic 12% Return 11 10 0% Risk 5 10 15 20 25 Global Morningstar Advisor Poll: Fund Manager the Decade (384 respondents) Domestic Equity Bruce Berkowitz Don Yacktman Charlie Dreifus Joel Tillinghast Steve Romick International Equity 41.4% 19.7% 13.4% 13.4% 12.1% Jean-Marie Eveillard American Funds EuroPacific Team David Herro Dennis Stattman Manning & Napier Team Fixed-Income 53.9% 25.6% 7.8% 6.9% 5.8% Bill Gross Dan Fuss and Kathleen Gaffney Dodge & Cox Income Team Jeffrey Gundlach Christine Thompson 60.8% 19.0% 9.2% 8.6% 2.3% Advisors, Morningstar Pick Managers of Decade Before Morningstar’s fund team named Bruce Berkowitz, David Herro, and Bill Gross its Fund Managers of the Decade, Morningstar Advisor asked advisors who, of the finalists for the official Morningstar awards, their favorite managers of the past 10 years were. The results of the poll were unequivocal—all three winners were of the landslide variety. At the helm of Fairholme FAIRX since its inception in December 1999, Berkowitz has seen the fund grow from a few million dollars in assets to more than $10 billion today. Berkowitz’s strategy has led to a stellar long-term record, and his large cash stakes have helped limit volatility: Fairholme earned a 13.2% 10-year annualized total return through Dec. 31, 2009, beating the S&P 500 by 14 percentage points. Morningstar also named Berkowitz its 2009 DomesticStock Fund Manager of the Year, and Fairholme is a Fund Analyst Pick. “Bruce Berkowitz secured a spot for himself among the elite stock-pickers this past decade,” says Karen Dolan, Morningstar’s director of mutual fund analysis. “He has executed his approach masterfully by revamping the portfolio multiple times over the last 10 years in a continuous effort to find the best bargains.” Advisors differed from Morningstar’s analysts when it came to foreign stocks. Jean-Marie Eveillard has long been a favorite of advisors, and he succeeded with a flexible mandate and plenty of caution. He retired (twice) before the decade ended. The analysts’ choice, Herro, used his value-driven approach to his advantage: Oakmark International Small Cap achieved an annualized return of just more than An efficient frontier, consisting of only domestic stocks and domestic bonds (represented by a 20-year U.S. government bond), can be generated in an effort to identify the combinations of stocks and bonds that maximized expected returns for a given level of expected 20 Morningstar Advisor February/March 2010
Morningstar Advisor - February/March 2010

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