There is no place like home…except in the Equity Markets!
December 1, 2017
Geographic diversification is a key driver of portfolio performance. Although many US investors exhibit a home country bias, for a US-based investor there are many arguments for allocating at least 35% of a global equity portfolio to non-US equities.
Focusing on recent returns, specifically the last 10 years of predominantly post-crisis performance, International equities have lagged US stocks by a significant margin. So, based on recent return trends, many US investors would assume that there is no reason for international diversification. (See Figure 1 below. The All Country World Index, or ACWI, encompasses the USA, WORLD EX-US and EM indices.)
Looking back on the prior 10-year period however, the opposite was the case, with International and Emerging Market equities outperforming US equities by 42.5% and 89.0%, respectively, over that period. This was clearly additive to overall portfolio performance (See Figure 2 below.)
Source: 2017 MSCI Inc. MSCI IMI Indices capture large, mid and small cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 8,582 constituents, the indices are comprehensive, covering approximately 99% of the global equity investment opportunity set.
Investors might also be inclined to chase performance based on recent experience and increase their allocations to the best performing geographies. The classic problem with that approach is that market timing is tricky at best and typically prone to failure. The only effective solution is to maintain consistent International exposure to capture the benefits of relative value and performance by different geographies over longer periods of time.
Although we at Versatile would never claim to predict the direction of the financial markets, there is a case to be made for better relative value in International and EM markets at this time, even in light of very strong performance this calendar year. Looking at trends in relative dividend yields, trailing and forward P/E’s, and price-to-book value ratios, International and EM equity markets are still cheaper by every measure.
Source: 2017 MSCI Inc.
Finally, from a volatility perspective, to the extent that it ever plays a role again in markets (and it most likely will in our investing lifetimes), a globally diversified portfolio should exhibit lower overall volatility. The most recent period has not been indicative of this effect, but, looking back over longer time frames, an allocation of between 20 and 50% in non-US equities has resulted in a roughly 50bp reduction in annualized portfolio volatility. (Source: Vanguard, Addressing clients' concerns about international equities: Performance, January 2016)
This can also be seen in correlations across global equity markets. Looking at the table below, the trend in correlations has fallen to the lowest levels since the mid-1990s.
In conclusion, although recent performance has given the markets and investors’ confidence in a home-centric bias in their equity portfolio exposure, consistent International exposure in portfolio construction enhances return and reduces volatility over longer time horizons. No one knows what market segments will outperform year-to-year. As such, Versatile Capital constructs portfolios to capture the growth of the global economies through International diversification. Diversifying within the home market is not enough, especially at the current valuations of US versus International markets.
1 Diversification doses not eliminate the risk of market loss.
Investment Advisory services are offered through Versatile Capital Management, LLC, a Registered Investment Advisor.
This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.