Why Diversify Outside The U.S.?

by: Ron Sanders

As retirement investors review their third quarter statements, one aspect that will likely stand out is the relative strength of the U.S. equity market. For the three months ended September 30, 2014 the U.S. equity market (represented by the Russell 3000® Index) outpaced international equity markets (represented by MSCI World All Country ex-U.S. Index) by nearly 6%. For periods ending September 30, the one-year difference between U.S. and non-U.S. equity performance was over 11% and the five-year annualized difference was almost 9% per year. Even for the 10-year period, U.S. equity markets outpaced their non-U.S. counterparts by almost 1% per year.

A natural conclusion may be: “What’s the sense in diversifying my investments outside the U.S.?” You could argue that for the last ten years, investors would have been better served by keeping their entire equity exposure in the U.S. rather than splitting it between the U.S. and non-U.S. equity markets, as the table below suggests.

Rseults are annualized. Standard deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk.

Results are annualized. Standard deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk.

But, what’s really going on here? Where is the additional return – or at least the benefit of lower volatility – that many investors typically expect from a globally diversified equity portfolio? Should U.S. investors truly consider abandoning non-U.S. equity investments given the experience of the last ten years? After all, ten years does represent a fairly long time horizon.

We believe the short-answer is “no,” but expanding on this should be helpful.

What happened in the past 10 years?

The past 10 years ending September 30, 2014 have been a unique period for equity markets. U.S. equities have experienced lower than average volatility during the last ten years (as compared to results since 1970, with U.S. equities represented by S&P500® Index from 1970-1978 and Russell 3000® Index from 1979-2014), despite the volatility of 2008-2009. Non-U.S. equity markets have also recorded higher than average volatility over that time period (same 1970 comparison, with non-U.S. equities represented by MSCI EAFE Index from 1970-1987 and MSCI All Country World ex-U.S from 1988-Sep 2014).

The two regions have posted similar enough returns that the usual diversification benefits experienced from holding both and rebalancing between the two regions was not realized during this period. Instead, 100% U.S. equity exposure was superior from both the return and volatility perspectives.

Global equity leadership will change over time

The reality is that global equity leadership will change from period to period. The chart below demonstrates the historical ebb and flow of the U.S./non-U.S. equity performance relationship over ten-year horizons.

Rolling Ten-Year Annualized Excess Return U.S. Equity vs Non-U.S. Equity

This chart reveals, among other things, that it was not so long ago that non-U.S. stocks were beating U.S. equities. Of course, during that period few investors were challenging the benefits of non-U.S. equity diversification. Nor were many questioning the benefit of maintaining an exposure to U.S. equities either because of home country bias.

Over longer time horizons, the benefits of this changing leadership (or diversification) can be seen in the market and in results of hypothetical index portfolios, as those represented in the table below. Like the first table, this table below shows annualized return and standard deviation for different mixes of U.S./non-U.S. equity exposure. The difference in this table is that it goes beyond the most recent ten years, back to 1970. This longer time horizon demonstrates the benefit of having exposure to both U.S. and non-U.S. equities over time.

Returns are annualized.

Returns are annualized.

Despite the non-U.S. market return trailing the U.S. return for the period from January 1970-September 2014 by a bit, the different return pattern of non-U.S. stocks relative to U.S. stocks made it beneficial to have equity exposure to both regions. A hypothetical equity portfolio split between 75% U.S./25% non-U.S. equities (or even 50/50) produced a modestly higher return than the 100% U.S. equity portfolio – but at a noticeably lower level of volatility.

The bottom line

Retirement investors should be aware of the influence of home country bias in their investment decisions, especially during times when the home country is outperforming other regions. Remind yourself that diversification tends to be a beneficial strategy over time, but its benefits aren’t always clear over shorter horizons when one asset class is dominating.

History has shown that market leadership changes. Yesterday’s winner is often tomorrow’s laggard. A diversified, global perspective tends to benefit the disciplined investor.