PMC Weekly Review - December 22, 2017

A Macro View: The Case For International Equities

Since the financial crisis, equity market returns have rewarded US investors for sticking with the familiar. From March 9, 2009 through November 30, 2017, the S&P 500 Index returned 285%, and the Russell 2000 Index has returned 292%. Meanwhile, international markets have failed to keep pace. The MSCI ACWI ex USA Index has returned only 130%, and the MSCI EM Index has delivered 126% over the same period. The divergence between domestic and international equity markets has benefited US investors, who tend to carry a home-country bias in their portfolios.

A home-country bias is a behavioral bias in which investors are inclined to favor local markets over foreign markets when making portfolio allocation decisions. Familiarity is a major driver of this decision, as investors tend to be more optimistic about markets with which they are familiar and pessimistic and indifferent to unfamiliar markets. US investors are particularly guilty of this. A Vanguard study showed that US investors allocate 79% of their equity holdings to US markets, the highest proportion of domestic holdings of any major market in the world. In contrast, only 55% of Japanese and 26% of UK investors select domestic stocks.

Based on recent results, it could be easy to conclude that US-based investors are better off sticking with US equities. However, this is a short-sighted view, as markets move in cycles, and US equities will not always remain the market leader. This is apparent from the recent past. From 2003-2007, emerging markets was the highest returning asset class for five consecutive calendar years. Additionally, from 2002-2009, international developed stocks outperformed US stocks in seven out of eight years. Even with its recent outperformance, the international market has outperformed the US in 14 of 31 years since 1986.

Despite the recent leadership of US stocks, it is clear that a well-diversified portfolio should include a substantial allocation to international stocks: It can decrease volatility and improve risk-adjusted returns over longer time periods. From 1950-2015, a globally balanced portfolio (70% US/30% International) performed in line with an all-US portfolio, but had both lower volatility (13.2% vs. 14.4%) and a higher Sharpe Ratio (0.54 vs. 0.51). So despite the increased risk of foreign equity markets, the diversification benefits can reduce risk in a portfolio.

Finally, investors should consider fundamental reasons for increasing exposure to foreign equities. As US equity markets have outperformed, they have become more expensive. By most valuation metrics, US markets are trading at historically high levels. In fact, StarCapital Research recently ranked the US as the least affordable equity market in the world, based on its metrics. Foreign markets are much more attractively valued on a relative basis, particularly emerging markets. Substantial evidence demonstrates that undervalued markets will achieve higher future returns than overvalued markets.

US investors’ home-country bias has favored US over foreign equities, which has paid off in recent years. However, plenty of evidence supports increased international exposure for many US investors. Additionally, domestic equity outperformance has been cyclical, and both recent performance and current valuations suggest that international stocks may be ready for a period of leadership. Thus, investors with US-heavy portfolios should consider reducing US exposure in favor of international markets.

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Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

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