Are the benefits of international equity diversification finally returning? From a performance and correlation perspective, it sure seems like a possibility.
Allocating to a globally diversified equity portfolio has been an incredibly frustrating endeavor for a long time now. We get it. Since the financial crisis of 2008/09, U.S. equities have trounced international equities by +90% on a cumulative return basis through 2016 (see the table below). Investors were basically penalized for investing outside the United States. However, since the beginning of 2017, things have started to change.
1. Returns have begun to favor international equity over U.S. equity
2. Lower correlations signal that now is time to maximize the diversification benefits of international equities.
Our prior blog (Is International Equity Outperformance Just Beginning?) discussed the recent outperformance of international equity and why we believe international stocks have begun to outperform U.S. stocks. To recap, the table below highlights the performance comparison between U.S. equity (S&P 500 TR) and international equity (MSCI ACWI Ex-USA Index NR USD (“ACWX”)) since January 2008. After 9 years of massive underperformance, international equity has finally begun to play catch up. Even a globally diversified portfolio has outperformed the S&P 500 TR Index. For simplicity, we use a portfolio allocation of 75% S&P 500 and 25% ACWX; the cumulative total return is +25% since January 2017, outperforming the S&P 500 by nearly +100 bps.
For RIAs and other advisors, the more intriguing piece of this allocation puzzle is the recent decline in correlations thus making the diversification benefits of international stocks look more attractive. Looking at the data, we see again that something in the relationship between international equity and U.S. equity has changed over the last 15 months or so. While the correlation change from +0.56 to +0.40 might seem insignificant, the resulting change is equivalent to a -28% drop in correlation. The same is true with Emerging Markets, where correlations have declined by -32%. The less these markets move in lock-step with the U.S., the greater the case for increasing your international equity allocation.
From an asset allocation perspective, it is nice to see the benefits of international portfolio diversification finally returning. The combination of international equity outperformance and lower correlations should increase the attractiveness of allocating globally thereby increasing the diversification of the entire portfolio. Only time will tell if these trends continue, but if they do, the benefits of holding international stocks will be enormous.
If you are interested in furthering this discussion, please reach out to the team. We welcome the conversation.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF RICHARD PELL
Richard Pell is CEO and Portfolio Manager at R Squared Capital Management.
Richard co-founded R Squared Capital Management in May of 2013. Prior to that, he was Chief Executive Officer and Chief Investment Officer of Artio Global Management LLC, a position he held since 1995 when the firm was part of the Julius Baer Group. Richard also served on the Board of Directors at Artio.
To read Richard's full bio or other RSQ team members, click here.