As the global markets become increasingly interconnected and the U.S. represents an ever-decreasing share of the world’s capital markets, plan advisors and asset allocators must continue to evaluate the role of international diversification in their DC investment lineups.
There is no question that the U.S. equity markets have been on an upward trajectory over the last five years, making that one of the best markets in which to invest. The question is, on a relative basis, whether or not it will remain so in the years to come. The short answer is that no one really knows which of the developed or developing markets will outperform on a relative basis in the future.
An article in last week’s USA Today, “Why Invest in International Funds? It's a Mystery,” suggests there is no need to consider international investing since, it asserts, why anyone would invest outside the U.S. is a “mystery” — one that is more “vexing” than how the “Egyptians built the pyramids.”
The author of the article, John Waggoner, points out:
Since the start of the bull market in March 2009, investors have yanked a net $421 billion from U.S. stock funds, but invested a net $342 billion into international funds … In the normal course of events, investors tend to put money into whatever is making money. But since March 2009, foreign markets have been laggards. The Standard and Poor's 500-stock index has soared 191% with dividends reinvested. The MSCI Europe, Australasia and Far East Index (EAFE) has gained 103%.
The overriding theory espoused by the article seems to be that investors need not look beyond the shores of the U.S. to achieve the best return:
But do international funds help your portfolio? In terms of return, it's hard to argue that they have, at least within most investors' experience. The past 25 years, large-cap U.S. funds have gained an average 691%, vs. 338% for international funds. U.S. funds have beaten international funds the past five, 10, 15, 20 and 25 years.
Given the recent performance of the U.S. equity markets and even the long-term performance of the U.S. economy, which has led the world (once Japan got knocked down) for much of the past century, it is hard to argue, based on a pure backward-looking basis, that the U.S. was not the place to be invested.
The Wall Street Journal presents a different view in a recent article, “Investing for the Long Term: How to Play Trends That Will Move Markets for Years to Come.” Rather than being backward-looking, this article, as is obvious by the title, is forward-looking. The author cites four trends to consider, one of which is pertinent to international investing: demographic shifts. The article notes:
The populations of emerging-market nations are growing at a fast clip, a good reason to maintain exposure to those economies, which will become a larger part of global demand despite setbacks over the past year.
For the plan advisor or asset allocator, this issue need not be an either/or decision based on past performance. Projected future returns aside, the argument for investing internationally can be justified based on the fact that whichever markets will outperform over any time period is largely an unknown. Furthermore, as global funds have generally proven, adding an international component to a portfolio helps smooth out the peaks and valleys and, thus, lowers day-to-day investment volatility.
It is popular to say that the global economy is so interconnected that everything has a correlation of 1. However, a closer look at recent correlations among global markets presents a different picture. The fact is that during the recent bull market, the average correlation among most of the major stock markets around the world is about 0.46. Looking at a recent one-year period, it drops to 0.40. (A global equity market correlation matrix covering all the major stock markets around the world can be found here.)
It will be interesting to see what 2015 holds for the U.S. and some of the international markets, especially Emerging Asia, which Goldman Sachs has made a recent bullish call of 15%-17%. Meanwhile, CNBC reports that Soros Fund Management, the large family office that manages assets for billionaire George Soros, “raised its protection against a U.S. stock market drop dramatically, sparking concerns that the powerful investment firm is expecting a big fall in [U.S.] equities.” Soros holds puts that, if converted to money, would mean that the “notional value of the bearish position is roughly $2.2 billion.” This is a big bet by a solid money management firm that 2015 will be a tough year for U.S. equities.
Conclusion
To quote Warren Buffett, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Could the same be said for country-specific markets as well?
The focus should not be on which markets were the biggest outperformers for the last 30 years, but rather on which markets will be the best performers over the next 30 years. Of course, given all of the variables to analyze (e.g., demographics, maturity of capital markets, current valuations, growth rates, military prowess), it is best to not be overly predictive as to which markets will outperform over the longer term.
The prudent approach (and as advisors governed by ERISA, we are called to such a standard) is to simply diversify across the global markets assuming that most (but not necessarily all) of the “known knowns” are built into the price of a given country-specific market. However, as former U.S. Secretary of Defense Donald Rumsfeld famously said, there are also “known unknowns” (e.g., China’s real growth trajectory) and “unknown unknowns” (e.g., black swans) that are not built into market prices. In the end, diversification is our best defense against these unknowns.
In terms of the impact of those investors who have yanked a net $421 billion from U.S. stock funds but invested a net $342 billion into international funds, the effect of these choices is, well, unknown. Perhaps on balance these investors will come out ahead, having locked in some gains while, at the same time, buying into an undervalued asset class. Only time, not prognosticators, will tell.
