To help us think through our asset allocation plans for the coming year, we compounded the annual returns of some key asset classes and plotted them. We are a bit torn between different views. The long-term view and the short-term view give conflicting guidance. Long-term performance data suggests international investing may not be all that fruitful. Short-term performance data suggests it is a winning strategy. Does the long-term reveal the true tendencies? Or, does the short-term, reveal a new investing regime?
Clearly, those who invested in diversified non-US investments did better than those who did not in the past few years. The YTD and 3 Year charts below demonstrate that. But the long-term record is dismal.
Investing in international companies is a fairly hot topic these days, and many analysts have said that more opportunity exists outside of the USA than within it. Those analysts point to the sorry state of US deficit, national debt, Chinese currency diversification of its national surplus, likely decline of the US dollar, and the relatively more attractive stock market valuations abroad. They are taking a forward look, as the markets are believed to do, and those analysts may be right.
On the other hand, some say past is prolog and that historical results and trends are better predictors than opinions about the future. Our plot of 10 year compounded returns paints an unattractive picture of developed and emerging non-US markets.
The graph below shows that over the 10 year period 1996 - 2005 investors who did nothing but keep their money in a money market account would have done approximately as well as investors in developed foreign markets (proxy ETF: EFA), or emerging markets (proxy ETF: EEM). That's terribly disappointing given the risks taken and the roller coaster ride along the way.
If an investor had the stomach, patience and foresight (or should we say clairvoyance) to trade in and out of the foreign markets (buying, selling and buying the MSCI EAFE; and selling, buying, selling and buying the MSCI Emerging Markets) a good size gain could have been made. We aren't into woulda-coulda-shoulda though, and this review is about asset allocation and not about trading.
The big asset allocation question is whether adding a popular international ETF like EFA or EEM is a good idea.
The picture we get from the graph is that they weren't a big help in the past. They fell significantly behind holding a 100% bond portfolio (Lehman Aggregate Bond Index, proxy ETF: AGG). The MSCI EAFE (proxy ETF: EFA) barely nosed out the Vanguard money market fund [symbol: VMMXX]. The MSCI Emerging Markets index was under water almost the whole time and ended up with a 24% loss, but few if any investors would have held on past the point where they had a 66% loss.
Maybe it's their turn to shine, and maybe it isn't. It would be hard to bet too much retirement money on the generally unsupported headline reports of analyst enthusiasm for non-US companies, while at the same time seeing the underperformance of the EAFE and the devastation of the emerging markets over the past 10 years.
REITS have been the super stars. They did well during falling interest rates and have done well (even better) during rising interest rates. Clearly, that class needs more thought and investigation. We don't know yet what to think about REITS.
The overall bond market (proxy: AGG) has been a steady performer with a pre-tax 82% gain, but the large-caps and mega-caps (proxy ETF: IWB) were the real winners among diversified indices with a pre-tax 142% gain. The small-caps (proxy ETF: IWM) did just as well as their larger brethren in the end, but for most of the time were lackluster by comparison. On the other hand, the heavy decline among the larger stocks beginning before the Dot.Com bust was too much for many.
We think that the Russell 1000 has so many globally diversified companies that the degree of international exposure from an ETF like IWB may be all many investors need.
2006 YTD Performance (as of November 24, 2006):
YTD 2006 returns for a near 11 year period don't change the story too much. MSCI REIT index continues to go through the roof. MSCI EAFE surpassed money market funds, but is still behind the Lehman Aggregate bond index. MSCI Emerging Markets index is still under water, although it has been charging up a strong rate. Russell 1000 and Russell 2000 are now about equal, but the small-cap index is trending up faster than the large-caps. The rotation between large-cap and small-cap appears to be happening in the last 3 months or so. The Russell indices are still a good place to be for diversified portfolios.
These charts form www.BigCharts.com demonstrate the strong short-term relative performance of non-US stocks and of REITs.
This YTD weekly chart shows REITs the runaway winner.US stocks and bonds bringing up the rear.
This 3-year monthly chart shows emerging market stock the runaway winner, with REITS and EAFE stocks in powerful pursuit. US stocks and bonds still brining up the rear.
Does the recent strength in the non-US stocks represent a new and lasting strength, or does it represent a catching up for miserable long-term performance?