Diversification paid off in strong H1 for global markets

This isn't an academic exercise, because having a sense of where the markets are headed depends to a large extent on understanding where they've been. We'll use the Dow Jones Wilshire Global Total Market Index, which tracks nearly 12,800 stocks in 57 countries. The Dow Jones Wilshire 5000, including virtually every exchange-listed stock in the United States, is the US component.

The global index rose 10.58% in the H1, counting both capital appreciation and cash dividends. While US stocks gained 7.56%, stocks elsewhere around the world jumped 12.95%. That kind of growth outside the United States has been going on for some time. As recently as November 2005, the US stock market accounted for more than half the world's equity market capitalization, but as of June 29 it was 42.8%. Developed markets other than the US gained 12.18%. Emerging markets blew the roof off with an 18.47% increase. Small-cap stocks in the emerging markets rocketed a jaw-dropping 31.70%, which looks like a full-year return and not just for six months. Small-cap stocks were the best performers globally, with a 13.58% return, followed closely by mid-caps at 13.13%. Large-cap stocks “trailed” with a 10.22% advance. This pattern held everywhere except in the US market, where mid-caps outperformed with an 11.74% return vs. 9.75% for small-cap stocks and 7.31% for large caps.

Geographically, the best-performing region was the Americas, excluding the United States, with a 22.16% jump. Peru was far and away the top market in the Americas with a 59.76% return. And that wasn't an aberration but a continuing trend; Peru's return last year was 83.37%. Among other Americas countries turning in solid returns were Brazil (33.43%), Chile (27.51%), Mexico (19.77%) and Canada (19.70%). The laggards were Argentina (up 5.30%) and Colombia (8.03%). The next-best region was Europe, with a 12.76% return. The hot-shot performers were Slovenia (a leap of 58.04%, following a 73.25% advance in 2006) and Iceland (up 51.21%). Robust returns also issued forth from Bulgaria (32.25%), Turkey (31.91%), Finland (27.56%) and Portugal (27.30%). Bringing up the rear were Ireland (up 1.89%), Italy (7.10%) and Switzerland (7.77%). More important for Europe was the enduring strength of its big markets. The United Kingdom gained 10.42% vs. 32.47% for all of last year, Germany added 24.04% on top of 38.23% in 2006, and France advanced 14.56% after rising 37.60% last year.

Among the 10 global industries, the leader/laggard split for the H1 was 50-50. On top were Basic Materials (26.00%), Industrials (18.44%), Oil & Gas (15.65%), Telecommunications (14.71%) and Utilities (10.63%). Dragging on the global return of 10.58% were Financials (4.37%), Health Care (4.67%), Consumer Services (7.49%), Technology (9.29%) and Consumer Goods (9.61%). However, eight of the 10 improved their performance in the Q2 from the first, with only Consumer Services and Utilities decelerating. But just four have H1 2007 returns that are greater than 50% of their 2006 performance: Basic Materials; Oil & Gas; Industrials, and Technology.
The leading and lagging industries were pretty much the same outside the United States as within it during the H1. US Technology and Health Care were a bit stronger than elsewhere, while Financials, Consumer Goods and Consumer Services did better on an ex-US basis. US Financials was the only industry with a H1 decline (1.11%) stemming from the supreme mortgage collapse. On the sector level, the standout globally was Industrial Metals (35.37%), propelled by Aluminum (43.79%) and Steel (38.45%). The weakest sector was Pharmaceuticals and Biotechnology, which gained 3.16% because the 3.76% advance by the big drug makers offset a drop of 0.32% in biotech. Aluminum took honors as the best-performing sub-sector globally, followed by Coal (38.45%). Marine Transportation (34.63%) and Farming and Fishing (33.53%) also were strong performers. On the spectrum's other end, Home Construction fared the worst with a decline of 13.03%, followed by a 1.73% retreat for Real Estate Investment Trusts.

Where were the sweet spots around the globe in the H1?
Poland took the top two positions with Steel (156.90%) and Specialty Chemicals (145.83%), followed by South Korea with Industrial Machinery (129.53%). The top 10 dropped down to Pakistan with Insurance (113.66%). The wrong-place-wrong-time award went to Spanish Real Estate (down 35.41%), followed by Japan with Business Training and Employment Agencies (off 29.04%) and Canada with Biotechnology (26.20% lower). Home Construction in the United States was next, falling 26.06%. (All these country sub-sector indexes have at least three stocks.)
This amount of granularity is of limited practical use - I don't know of any index fund for Polish steel companies. But it is interesting to see that the industry-leading performances of Basic Materials and Industrials extended down to the country level. From the indexed investor's viewpoint, though, it is far better to have broad exposure to stock markets than to attempt identifying specific sectors in certain countries. The pinpointing game is for hedge funds, whose tracks appear to be all over these performance results, on both the upside and downside.

For the individual investor, diversification is the best game plan, and it continued to pay off in the H1. In a piece earlier this year I proposed a portfolio for US index investors that allocated 35% to the Dow Jones Wilshire 5000, 5% each to the Dow Jones-AIG Commodity Index and Dow Jones Wilshire US Real Estate Securities Index, and 40% to the Lehman Aggregate US Bond Index. In the Q1, this portfolio had a return of 2.1%, despite the late winter tumble in the US stock market. The performance sped up to 2.6% in the Q2 - notwithstanding a negative return in June, which was the first in a year - making for a H1 advance of 4.8%. EAFE had the best performance in both the Q1 and Q2, rising 11.09% for the six months. DJ Wilshire US RESI had a positive return in the Q1 but plunged 9.35% in the second, resulting in the worst H1 showing with a decline of 5.96%.

So, you're asking how a 4.8% return for the diversified portfolio “pays off” in comparison to a 7.56% return for the US stock market. The answer is reduced risk.
The diversified portfolio had an annualized volatility (standard deviation from the average return) in the H1 of 3.91%, compared to 8.49% for stocks. The bottom line is that the diversified portfolio had a risk-adjusted return equivalent to that of the stock market in the first six months, because its 54% lower volatility made up for its 36.5% poorer nominal return. (marketwatch.com)

John Prestbo is editor and executive director of Dow Jones Indexes, a unit of Dow Jones & Company, Inc., publisher of MarketWatch. Scott Lang and Jeffrey Fernandez contributed research to this article.