International Equity: An Important Portfolio Component
During the first half of the year, one of the key themes we have been covering in our monthly market commentary is the “re-opening trade.” As the economy re-opened after months of lockdown, value stocks tended to perform better than growth. At the same time, U.S. markets outperformed overseas markets, as the rest of the world has had a tougher time than the U.S. in getting the pandemic under control.
But this would be an opportune time to remind ourselves that all market trends end at some point and shift toward a new regime. We saw that as growth stocks reasserted themselves and delivered outperformance in June, after months of underperformance.
In the same vein, it’s important not to count out non-U.S. stocks for many reasons. Here’s how we think about the importance of global equity allocations at CAM:
- Why allocate?
The U.S. equity market is the biggest in the world by capitalization. But typically, it is only about 50% of the global equity opportunity set. So if you’re only looking at half the world, it’s impossible to say that you’re selecting from the best investment opportunities in the world.
Of course, there are sustained periods when U.S. equities outperform. For example, since 2010, only twice have foreign stocks outperformed U.S. stocks. But there are also periods when non-U.S. markets outperform, such as the 1980s, when foreign stocks outperformed in all but two years. In fact, over the past 50 years, its nearly evenly split, with foreign equities outperforming in only 26 of the 50 calendar years.
The disparity in performance across global markets is the foundation of a basic investing principle of diversification. And while correlations among global market are creeping higher — i.e., American companies derive large chunks of revenue abroad, and non-U.S. multinationals are often leaders in U.S. markets (e.g., Samsung, Nestle) — there’s still enough performance diversification to deliver an overall benefit to the portfolio.
- How do we do it?
How much should I allocate overseas is an obvious question. Academic research is mixed concerning the optimal allocation, but 30% falls into the most accepted ranges. We are comfortable with that level of exposure. However, there are other important considerations as well. Should I hedge currency risk? What about foreign bonds?
We don’t hedge currency risk for two simple reasons. It is expensive and currency volatility is an important driver in lowering the correlation between U.S. and foreign markets. As for bonds, we believe the combination of tight correlations between U.S. and foreign bonds and extremely low (and even negative yields) in foreign markets simply make it an unattractive addition to a diversified portfolio.
Lastly, we believe that the most important issue here is capturing the asset class exposure, rather than trying to pick winners at a given point in time, with respect to country, company, or even investment theme. Therefore, we focus on passive ETFs as the optimal investment vehicle, given their tax efficiency, liquidity, and ease of trading in these foreign markets.
- Diversify your home bias:
Finally, what most U.S. investors forget is that, for most of us, nearly all our wealth is tied to the U.S. economy — investors called this a “home bias.” The value of your business is tied to the U.S. economy, as is the value of your house, as is your salary. A certain amount of home bias is appropriate, given that it’s the economy you’re living (and spending) in. But diversifying a material portion of your invested assets may play an important role in mitigating any risks embedded in that home bias.
As the world slowly emerges from various forms and degrees of lockdown, the re-opening trade continues, even if a bit unsteadily. Equities have been very volatile at mid-year, as COVID variants spread, vaccination programs stall, and infection rates tick upward, even in large swaths of America. Once again, it’s a reminder that regimes never last forever, and sometimes the shifts can be sudden and surprising.
That’s why, as investors, we rely on the principle of diversification to mitigate risk, as well as provide a greater universe of opportunity. Non-U.S. stocks have been underdogs for a while now, but if history is any guide, they will have their day once again. And investors don’t want to be caught flat-footed chasing a rally on the way up, better to take a long-term view and keep those allocations in place in both bad times and good.
Author
Mitch York, CFA®
CIO
Concord Asset Management
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