Take action today. Call our experts at: phone icon1-800-522-5221

AAFMAA Blog

Global Diversification is Still Beneficial

2020-01-20

Boosted by favorable economic news, including better-than-expected corporate earnings reports, the S&P 500 Index has once again reached  historic highs.

It's an impressive performance when one considers the stream of headlines that might have suggested otherwise. Trade wars, impeachment drama, recession fears, and ongoing geopolitical turmoil in Hong Kong, the Gaza Strip, and Chile (to name just a few) are some of the headwinds that immediately come to mind.

International equities, representing both developed markets and emerging markets, have generated decent performance this year but continue to lag U.S. markets. Since the market bottom in 2009, U.S. stocks have been the place to be.

Current sentiment is the opposite of what occurred during the mid-2000s, when excitement over the BRIC markets (Brazil, Russia, India, and China) led international equities over U.S. equities. AAFMAA Wealth Management & Trust LLC (AWM&T) Chief Investment Officer, Arthur Lyons, remains cautious on international equities. As he stated in his recent 3rd Quarter Commentary, we reinvested part of our allocation in U.S. equities, where Arthur continues to see better overall opportunity.

But note that our allocation to international equities is not zero; we still maintain positions across several key strategies.

Here are a few benefits to consider with international investing:

  • Investing overseas offers more opportunities. About half the world’s equity market capitalization consists of non-U.S. companies. Many leading, innovative companies are based outside the U.S. and listed on foreign exchanges. Why exclude such investment opportunities simply because of geography?

  • The cost of international investing continues to fall. According to Morningstar, the average actively-managed international fund charged a management fee of 0.82% in 2018 versus 0.93% in 2015. This trend is likely to persist.

  • Globalization will continue. Rising populism in many parts of the world, including the U.S., is unlikely to derail the growing level of exchange across geographic borders.

The problems facing both developed and emerging market countries are widely-known.

Many developed market countries, particularly in Europe, are structurally challenged. Politicians either lack the will or popular support needed to make reforms to unresponsive labor markets, generous welfare systems, and uncompetitive tax codes. These issues, among others, result in economies that barely grow.

Many emerging market countries lack a durable legal framework that protects property rights. As a result, they often have corrupt or unstable ruling regimes and are prone to debilitating currency devaluations.

The volatility of emerging markets can be nerve-wracking. Writing for Fortune.com, Ben Carlson notes that since 1994, emerging markets have experienced twice as many double-digit declines as the S&P 500. There have been 13 separate periods of 20%+ emerging market losses versus only two for the S&P 500.

Is it any wonder so many investors question diversifying into non-U.S. equities?

One oft-cited criticism of international equities is that it no longer offers U.S. investors much in the way of diversification. Statistically, the correlation between U.S. and non-U.S. markets is not as low as it once was, a result often attributed to globalization. Whenever U.S. equities experience a drawdown, international markets often decline as much or even more. However, this does not mean the concept of diversification is flawed or that there is no benefit from owning an asset class that has a high correlation of returns in the short-term to U.S. equities.

In the May/June 2011 edition of the Financial Analysts Journal, AQR Capital Management researchers Clifford Asness, Roni Israelov, and John Liew found international diversification doesn’t necessarily work in the short-term but does work over longer periods. In their study of 22 countries from 1950 through 2008, the authors noted that markets don’t exhibit the same tendency to crash together over the long run. The reason is that country-specific economic performance matters most for long-term returns, and regions tend to have variations in performance.

The superior performance of U.S. equities since the market trough in March 2009 reflects current valuation multiples. For example, the Vanguard Total [U.S.] Stock Market ETF (VTI) sports price-to-earnings (P/E) and price-to-book value (P/B) multiples of 20.3 and 3.0, respectively.

By comparison, the Vanguard FTSE Developed Markets ETF (VEA) is at a P/E of 14.9 and a P/B of 1.5. emerging markets, as measured by the Vanguard FTSE Emerging Markets ETF (VWO), is even cheaper at a P/E of 12.9 and a P/B of 1.6.

Estimating valuations across geographic regions is not quite an apples-to-apples comparison. The challenges above undoubtedly reflect current valuations. They’re the best judge of future returns we have, and suggest future returns of international equities, particularly emerging markets, will be higher than U.S. equities.

Keep in mind, just because international equities have trailed U.S. equities for an extended period does not mean this performance will continue indefinitely. Since there are no crystal balls, it’s best to maintain some exposure to international equities as part of a diverse portfolio.

At AWM&T, our vision is to ensure the financial security and independence of the American Armed Forces community by providing trusted financial planning, investment management, and trust services.

For a complimentary portfolio review, please contact us at wealthmanagement@aafmaa.com or call us at (910) 307-3500.

Sources:

1. Ben Carlson, “Learning to Love-or at Least Live With-Those Painful Stock Market Losses” Fortune.com, October 12, 2019.

2. Clifford Asness, Roni Israelov, and John Liew, “International Diversification Works (Eventually)”, Financial Analysts Journal, May/June 2011.