Investment allocation theory teaches that a portfolio’s return and risk can be improved by adding more investments with low correlation to other portfolio investments. Investors who have suffered through the risks offered by the U.S. stock market in recent years apparently agree: There has been a large increase in interest in “alternative” investments, such as hedge funds, venture capital and private equity. Instead, they might consider small international stocks, which have proved to be a more liquid alternative that apparently offers good diversification.
Recent studies of the other alternatives indicate they do not reliably diversify a portfolio, that their costs are high, and that they restrict an investor’s access to his funds. A study by two finance professors of private equity which is due to be published in the American Economic Review found that investment results were substandard compared to the Standard & Poor’s 500 Index. Returns on 5 million private businesses averaged 13.9% per year from 1990 through 1998, compared to a return of 17.9% for the S&P 500. Statistics on the growth in book values of private businesses from 1963 through 1999 also indicated slower growth than that of public companies. Several studies of venture capital projects indicated that despite some huge winners, on average such projects don’t beat the stock market by enough to justify the risk. Hedge funds, meanwhile, also appear to offer negative returns when adjusted for risk, according to a study by hedge fund manager Clifford Asness in The Journal of Portfolio Management.
Meanwhile, international small stocks during the period 1970 through 2002 offered higher average returns that U.S. stocks or large international stocks. They also were not highly correlated with U.S stocks. The correlation of international small stocks with the S&P 500 was just 0.29 during the period (with 1.00 being perfect correlation and 0 being perfect non-correlation). International small stocks were much more volatile than domestic stocks, indicating that an investor should mix holdings of international small stocks with domestic stocks.
They have an advantage over the investment alternatives described above because they are liquid and can be sold at any time on public exchanges. They also permit a mutual fund owner to gain high diversification by using a fund that holds many small international stocks.
