Maintaining a Globally Diversified Portfolio

Given their long underperformance relative to U.S. stocks, some investors may be questioning whether it makes sense to own international equities. Jared Kizer looks at five reasons why you should remain committed to a globally diversified approach.

Since the financial crisis of 2008, U.S. equities have earned substantially higher returns than international equities. Ken French’s data shows that the U.S. equity market has earned annualized returns of 15.6 percent per year from 2009 through 2017, while international equities earned 9.9 percent. Such periods inevitably lead some investors to question whether international diversification makes sense. This skepticism is reinforced by the fact that U.S. equities have outperformed international equities over an even longer period. The S&P 500 Index has outperformed the MSCI EAFE Index — its international equity equivalent — since the MSCI EAFE’s inception back in 1970. It’s easy to understand why an investor would believe that such a long period of outperformance must surely mean that U.S. investors should avoid international equities. This is all without mention of the current global equity environment thus far in 2018, where the U.S. equity market has trounced the equity performance of the international developed and emerging markets year-to-date.

While the preceding data may be enough to give any investor holding emerging markets stocks heartburn, it tells us little to nothing about the future performance of the U.S. equity market compared to other countries or to a diversified basket of international countries. Below, we’ll look at five lessons that I believe confirm the need to ignore such past performance and remain committed to a globally diversified equity approach.

1. Broad-based international index returns don’t relay the complete story.

Based upon the information presented above (U.S. equities have substantially outperformed international equities), where would you guess U.S. equity market returns have ranked relative to equity returns of the various countries included in international equity indexes? My guess is that you might say No. 1 or at least top three. Some might even be 100 percent confident that U.S. equity returns were at least in the top five.

You might be surprised that seven other countries generated higher equity market returns than the U.S. market over 1998–2017. Those countries from first through seventh were Denmark, Australia, Hong Kong, Canada, Singapore, Finland and Sweden. In terms of growth of a $1,000 investment, in Denmark’s equity market, it grew to $7,359 at the end of 2017. Compare that to $3,559 for the U.S. market. Does this mean you should allocate your entire portfolio to Denmark? Of course not, but it does show that nothing preordains higher returns for the U.S. market compared to other markets.

2. When looking at past performance, there will always be something you could have implemented that would have done better, but hindsight isn’t foresight.

While the performance of the S&P 500 has been stellar since the financial crisis, there are no doubt particular stocks and sectors that generated substantially higher returns than the S&P 500 overall. Would you then conclude that you should shift your U.S. equity holdings into those stocks or sectors instead of owning the U.S. market more broadly? I hope most investors would say no for at least two reasons. First, making these changes would reduce portfolio diversification, exposing the investment portfolio to the unnecessary risk of something happening to a particular company or industry. Second, past performance does not predict future performance.

These points are exactly analogous to global equity investing. Reiterating the final point made in the first lesson, it’s highly unlikely a U.S. investor would be willing to move their entire equity allocation over to Danish equities, so why would an investor be comfortable with having equity exposure concentrated solely in the U.S.? A portfolio composed of only U.S. equities is clearly less diversified than a globally diversified equity portfolio. Furthermore, a considerable body of academic research has shown that past performance not only fails to guarantee future results but has virtually no value as a predictor. Thus, the prudent strategy is to diversify globally and reduce the risk of having too many eggs in one basket.

3. International and emerging market equities remain a substantial fraction of the world’s equity market wealth.

As of year-end 2017, international and emerging market equities represented about 48 percent of the world’s equity market capitalization, with the U.S. market comprising the balance. This means that U.S. equities should likely be a substantial portion of one’s equity portfolio, but allocating only to U.S. equities would mean implicitly ignoring almost half of the world’s equity market wealth. Regardless of past performance, this is generally not a wise course of action.

4. The performance of globally diversified portfolios frequently diverges from the performance of the U.S. equity market and does so for extended periods of time.

Some investors may be surprised at how much the S&P 500 has outperformed the MSCI EAFE post-financial crisis, believing that the difference is so extreme that it must mean something. Examining the entire history of the performance of the S&P 500 compared to the MSCI EAFE quickly dispels this notion. Figure 1 shows the decade-by-decade total returns of each of the two indexes and the corresponding difference starting with the 1970s and continuing through the 2000s.

Figure 1: Decade-by-Decade Total Returns (S&P 500 v. MSCI EAFE)

Source: Thomson Reuters Lipper

Of the four decades, three involved substantially higher returns for either the MSCI EAFE compared to the S&P 500 or vice versa. For example, in the 1980s, the MSCI EAFE had total returns that were over 200 percent higher than the S&P 500, while the total returns of the S&P 500 were over 300 percent higher than the MSCI EAFE in the 1990s. This shows that investors should expect that the performance of globally diversified portfolios may diverge from the performance of the U.S. market without that being an indication that a globally diversified investment approach is no longer a prudent strategy.

5. Even longer-term outperformance does not indicate a continuing trend.

Look back at the first two decades of Figure 1. You will see that international equities dramatically outperformed the U.S. market over this 20-year period. In fact, the total returns of the S&P 500 were almost 800 percent, while those of the MSCI EAFE were almost 1600 percent. In other words, an investor who invested only in the MSCI EAFE would have turned $1 into almost $16, while the same $1 invested in the S&P 500 would be worth almost $8 (this example, of course, ignores expenses). A U.S. investor investing only in U.S. equities, no doubt, would have been kicking themselves for not diversifying globally and might have even been tempted to move most or all of their U.S. equity allocation to international equities. In practice, such a move might have sounded sensible — after all, our hypothetical investor just witnessed 20 years of stellar international equity performance (how much more data could one need?) — yet, the outcome of such a move would have been disastrous.

Even though U.S. equities have substantially outperformed a broadly diversified basket of international equities post-financial crisis, the right approach for most investors remains global diversification. The arguments and examples above point out that there is no reason to expect the U.S. equity market to systematically outperform over the long term, while noting that there will inevitably be periods when a globally diversified portfolio may underperform a portfolio concentrated solely in U.S. equities.

This commentary originally appeared August 16 on MultifactorWorld.com

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