July 7th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Global Diversification for the Long Term
- Following several years of underperformance relative to the S&P 500, international stocks have outperformed their US counterparts this year through June 19.
- Rather than making portfolio decisions based on periods of out- or underperformance, however, investors would be wise to consider a strategic allocation to foreign stocks, especially considering that an increasing share of global output is being generated by countries outside the US.
- Against the backdrop of an uncertain path for globalization given protectionist headwinds, plus economic and political uncertainty, global diversification would seem a prudent strategy.
- Gerstein Fisher research has shown that over time, a globally diversified, factor-based investing strategy bests a US-only portfolio.
When I last wrote, I provided some perspective on investing in a time of lofty US stock market valuations (see Fear of (Market) Heights). Part of the remedy for this challenge is to maintain–in all market environments–a globally diversified portfolio. In this column, I will expand on this notion and a few key benefits of maintaining foreign equity exposures in a portfolio.
Following an extended period in hibernation, foreign markets have sprung to life this year. Year-to-date through June 19, the MSCI All-Country World Index ex-US returned 15%, compared to 10.7% for the S&P 500 Index. During the six years from January 2011 to December 2016, however, foreign markets returned only a cumulative 13%, compared to 102% for the S&P 500. Some of the more recent foreign advantage can be attributed to the weak US dollar, which declined in value by 4.6% (as measured by the Dollar Index Spot) from January to June 22. Nevertheless, equity valuations abroad remain much less dear than at home: at the end of May 2017, the price-to-book ratio for developed markets (MSCI EAFE Index) was 1.7, compared to 3.1 for the US market.
Yet my advice for most American investors to increase foreign exposure isn’t premised on current strong performance (we are not tactical investors), nor even on the considerable valuation gap between foreign and US equities per se. Rather, most investors are afflicted by what is called in behavioral finance home bias—the tendency to invest too much domestically and miss diversification benefits from investing overseas. Other investors perhaps maintained a healthy allocation to foreign stocks years back but failed to rebalance asset class weightings during the years of US equities’ bull run. Overall, we estimate that Americans have only 20-25% of their equity portfolios in foreign stocks, whereas at least 30% to 35% may be more appropriate for many investors considering that, as of May 31, US and foreign stocks each accounted for about half of global stock market capitalization.
Winds of Economic Change
I also believe that some currents in the world economy buttress the case for deeper global diversification. For example, the US is a steadily shrinking engine of world output, accounting for 24% of global GDP now compared to 40% in 1960 (Source: World Bank); emerging markets’ share of global output has risen from 22% to 36% during the same time frame. It seems prudent for investors to take advantage of where the world’s economic growth may emanate from in the future. Even the opportunity set of investable companies is shrinking in the US, while it is expanding abroad. According to the World Bank, the number of US publicly listed companies contracted by more than 40% to 4,380 from 1995 to 2015, whereas foreign-listed stocks jumped 43% to 39,160.
The winds of trade protectionism are blowing in the US, and resistance to the forces of globalization is rising in many countries. Global trade flows have been stagnant in recent years following an extended period of growth. We cannot predict the future, but given the prospect of heightened trade conflict and economic nationalism, a strategy of allocating capital to a diversified mix of countries and companies seems sensible. Our research also demonstrates that international diversification can be enhanced by taking some capital away from the largest market-capitalization countries in a portfolio and redeploying it in smaller ones (see International Investing and The Small Country Effect).
In short, in a world punctuated by economic and political uncertainty and multiple possible paths for globalization, our approach is to embrace a globally diversified portfolio enhanced by factor investing, the practice of targeting specific risks with an aim of earning returns of better than the market. For illustrative purposes*, we compared the performance of the S&P 500 Index from 1970 with that of a global two-factor model**. For this research, we chose value and momentum, since these are two important investment factors for which data is available back to 1970. I should note, however, that other factors are subsumed into these factors. For instance, a tilt to value is by default also a tilt to more small-cap exposure.
Exhibit 1 demonstrates that a global factor-based approach to equity investing would have proven more lucrative over time than the home-biased one of investing merely in US stocks. If you had invested $1,000 in the S&P 500 Index in 1970, your money would have grown to about $100,000 by the end of 2016; but a globally diversified, two-factor portfolio would have multiplied to around $400,000 in value.
There will inevitably be periods—such as during the past several years—when the US-only portfolio outperforms. But from a risk-management standpoint, this is no reason to abandon the global strategy. Depicted in Exhibit 2, we examined every 10-year rolling period of returns back to January 1970 (approximately 450 observations), and found that the global two-factor portfolio held the upper hand in nearly 90% of cases. Those are odds that we like.