Agree to Disagree: A vote for international stocks
U-WEN KOK, CFA 28-Oct-2019
Jack Bogle, the legendary American investor and father of indexing, once famously suggested that investors “don’t need to own international stock.” Far be it for me to argue with such an iconic figure of American finance, but I respectfully disagree.
Yes, on any given day the international headlines can be downright gloomy. The U.S. – China trade spat continues, with ramifications for supply chains here and around the world. The Brexit showdown remains unresolved and hangs over European stocks. Measures of business confidence, specifically various global Purchasing Manager Indexes (PMI), have been on the decline year-over-year. And perhaps most concerning, yield curve inversions, whereby short-term rates have moved higher than longer-term yields, are portending to slower global growth and even hinting at possible recessions.
All this may seem like a dubious backdrop from which to build a case for international equities. Yet it is the very nature of such low-growth projections—something investors are dealing with while their longer-term return requirements are likely increasing—that argues for casting a wide net. Consider that the total market capitalization of all publicly traded companies within the MSCI All Country World Index (ACWI) was approximately $66 trillion as of September 30, 2019. Yet, 56% of this value is based outside the United States in global markets. For investors seeking an absolute return or some other definitive long-term objective, it would seem incumbent to broaden horizons in order to capture potential growth outside of the usual suspects—domestic stocks.
I believe that investing globally not only can improve long-term returns, but the shifting nature of regional economic cycles should lower correlations may offer significant diversification benefits. That could be especially important in the current environment. Yes, global markets have mostly underperformed domestic stocks over the past decade, yet some investors forget that this has not (and will not?) always be the case. If there is any reversion to the mean, a global allocation today could prove prescient. Of course international investing carries some additional risks not inherent to domestic investing—including currency, sovereign, and geopolitical risks—but adding global equities with different correlations may help investors weather market volatility when domestic stocks inevitably stumble.
Assuming investors don’t share the narrow “Jack Bogle” view, the question shifts to one of tactics. How should investors go about capturing the true potential of global equities? Here are three rules that investors can use as guardrails to put them in the best position to benefit from global equities:
- Avoid market timers. Historically, market timing has proven highly unpredictable and unrepeatable over the longer term. Much wiser would be to gravitate toward those strategies focused on stock selection and willing to adhere to stated investment principals and guiding philosophy at all points of the cycle. For example, I prefer focusing on quality and valuation factors as part of the stock selection criteria, among others. I believe that focusing on these investment characteristics not only can help achieve better risk-adjusted returns, but may also help keep portfolio volatility in check. Lower volatility has been proven to be a contributor to better long-term outcomes.
- Avoid single-country managers. Allocating to an array of single-country funds is likely to be quite costly if investors want to benefit from the diversification potential of global stocks. An easier way to execute is to find a manager with capabilities to go anywhere, rather than be bound to a specific region. A single manager with a wide geographic mandate should be better able to optimize overall portfolio risk and return exposure, as compared to a multi-manager-approach with separate country or region-specific mandates
- Embrace prudent risk managers. If we acknowledge that there are slightly higher embedded risks of investing globally, then vetting a manager’s risk protocols is of paramount importance. Understand if and how the manager aims to reduce portfolio volatility through diversification, and understand what portfolio construction guidelines are in place to minimize any unintended bets (relative to its benchmark). This also helps avoid style drift —i.e. chasing certain factors when they appear in favor even if it’s not part of the manager’s guiding investment philosophy.