If you have recently evaluated the performance of the different components of your portfolio, you are probably wondering why you maintain positions in international equities.
International equities, from nations that are both developed and emerging, have lagged U.S. equities since the end of the financial crisis, prompting many questions from U.S.-based investors.
Yet, despite their recent underperformance relative to U.S. equities, we have found that international equities offer numerous benefits: They play an important role in reducing U.S. investors’ “home bias”; they improve portfolio diversification and risk-adjusted returns; and they offer increased exposure to higher-growth economies.
As is the case with most financial markets, leadership ebbs and flows over time. This is especially true with regard to the relationship between international and domestic equities, which have traded outperformance cycles since 1971.
The current cycle has favored domestic equities, with the S&P 500 outperforming the MSCI EAFE from November 30, 2007, to December 31, 2015. This, in turn, followed a cycle of international equity outperformance (54 percent from August 2000 to November 2007). This trend is reflected in the current valuation of domestic and international equities, with the latter offering less expensive valuations.
Introducing non-dollar exposure naturally raises the question of currency hedging, or converting non-dollar exposure back to U.S. dollars. The decision to hedge foreign currency exposure is an important one: During 2014, the MSCI EAFE returned 6.4 percent in local currency terms while it declined -4.5 percent in U.S. dollars. And in 2015 (as of September 30), the returns were -0.6 percent and -4.9 percent, respectively.
Global equity correlations recently stood at 0.47 percent on a one-year basis, which illustrates the benefits of holding a diversified portfolio.
Numerous studies have found that investors exhibit strong “home bias,” or the tendency to overweight their exposure to domestic equities, relative to their country’s global market capitalization. This bias is particularly impactful for U.S.-based investors, given that U.S. equities represent over 50 percent of global equity market capitalization (MSCI ACWI, as of October 30, 2015). By making active bets and overweighting U.S. equities, U.S.-based investors may be missing out on the potential diversification benefits of international equities.
As mentioned earlier, owning internationally domiciled companies over the long term often results in reduced volatility at the portfolio level. This reduction in volatility is yielded by the changing correlations between U.S. equities and international equities; over time, there will likely be many instances when these two entities move in different directions.
As was the case for most of the first decade of the 2000s, economists are forecasting higher levels of growth for emerging-market countries relative to developed countries. In addition to gaining exposure to potentially higher economic growth, investors can gain an extra layer of diversification from asynchronous monetary policy and market cycles. In short, then, while international equities have underperformed in recent years, they remain a critical part of long-term asset allocation and portfolio management. For a more in-depth analysis of this topic, please see the OnePaper on our website.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy or product (including the investments and/or investment strategies recommended or undertaken by Waldron Private Wealth), or any noninvestment-related content, made reference to directly or indirectly in this essay, will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this essay serves as the receipt of, or as a substitute for, personalized investment advice from Waldron Private Wealth. Please remember to contact Waldron Private Wealth, in writing, if there are any changes in your personal/financial situation or investment objectives, for the purpose of reviewing/evaluating/ revising our previous recommendations and/or services. Waldron Private Wealth is neither a law firm nor a certified public accounting firm, and no portion of the essay content should be construed as legal or accounting advice. A copy of Waldron Private Wealth’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.
This article was originally published in the February/march 2016 issue of Worth.