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Since the financial crisis of 2008, U.S. equities have earned substantially higher returns than international equities. Ken French’s data shows that the U.S. equity market has earned annualized returns of 15.6 percent per year from 2009 through 2017, while international equities earned 9.9 percent. Such periods inevitably lead some investors to question whether international diversification makes sense. This skepticism is reinforced by the fact that U.S. equities have outperformed international equities over an even longer period. The S&P 500 Index has outperformed the MSCI EAFE Index — its international equity equivalent — since the MSCI EAFE’s inception back in 1970. It’s easy to understand why an investor would believe that such a long period of outperformance must surely mean that U.S. investors should avoid international equities. This is all without mention of the current global equity environment thus far in 2018, where the U.S. equity market has trounced the equity performance of the international developed and emerging markets year-to-date.
While the preceding data may be enough to give any investor holding emerging markets stocks heartburn, it tells us little to nothing about the future performance of the U.S. equity market compared to other countries or to a diversified basket of international countries. Below, we’ll look at five lessons that I believe confirm the need to ignore such past performance and remain committed to a globally diversified equity approach.
1. Broad-based international index returns don’t relay the complete story.
Based upon the information presented above (U.S. equities have substantially outperformed international equities), where would you guess U.S. equity market returns have ranked relative to equity returns of the various countries included in international equity indexes? My guess is that you might say No. 1 or at least top three. Some might even be 100 percent confident that U.S. equity returns were at least in the top five.
You might be surprised that seven other countries generated higher equity market returns than the U.S. market over 1998–2017. Those countries from first through seventh were Denmark, Australia, Hong Kong, Canada, > SEE MORE
I’ve followed the TIPS market fairly closely since I started in the advisory business in 2003, and we’ve used them for a portion of many clients’ fixed income portfolios (and continue to do so today). The year I started in the business was only a few years after the inception of the market, and we now have about 20 years of returns history to examine. In the early years, there was a very logical argument that TIPS should dominate the fixed income portfolios of individual investors because they were essentially the perfect fixed income security, issued by the U.S. government and linked to inflation. Since credit risk is redundant for most investors and individuals have spending that grows with some measure of inflation, TIPS seemed to have everything an investor could want. Further, the historical correlation between unexpected inflation and stock returns has been negative while it was expected to be positive for TIPS. This meant TIPS had the potential to provide more powerful diversification of stocks when compared with nominal Treasuries.
The reality of TIPS, however, has been more muddled. TIPS have exhibited bizarre behavior for stretches of history (e.g., in the years following the inception of the market and during the financial crisis). In the early years, > SEE MORE
The first half of 2018, like in any year, contained many challenges and surprises for investors. For example, investors were confronted with certain threats to equity returns, specifically, the Federal Reserve raising interest rates and tightening liquidity by starting to unwind its balance sheet, rising oil prices and threats of a global trade war, which also led to collapsing prices in some commodities.
Among the “surprises” were that, even though many investors had declared the size premium dead, U.S. small-cap stocks outperformed. For instance, using data from Morningstar, the Vanguard S&P 500 ETF (VOO) rose 2.7% this year through June 30 and the Vanguard S&P Small-Cap 600 ETF (VIOO) climbed 9.3%. That recent outperformance follows poor performance over the seven-year period 2011 through 2017. Using Fama-French data from Dimensional Fund Advisors, the annual size premium in the U.S. was negative in five of those seven years, with returns of -6.0%, -1.2%, 7.3%, -8.0%, -3.9%, 6.6% and -4.8%, respectively. The annualized premium was a negative 1.4%.
Another such “surprise” to many was the poor performance of developed international and emerging market stocks given their lower valuations and thus higher expected returns.
Earlier this week, I discussed why it’s so hard to be a disciplined investor, which generally is a prerequisite for being a successful one. Building on this theme, the “Factor Views” section of J.P. Morgan Asset Management’s third-quarter 2018 review provides another example of why successful investing is simple, but not easy.
Value Investing Has Been Painful
Over the last 10 calendar years, Fama-French data from Dimensional Fund Advisors shows that the value premium in the U.S. was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks.
Such long periods of underperformance will test the discipline of even those with a strong belief in the value factor. Compounding this issue is that, as the J.P. Morgan Asset Management report points out, since the beginning of 2017, the value factor has posted losses of nearly 15%.
Furthermore, the second quarter of 2018 was the value factor’s second worst since 1990. The result, the report states, is that “the factor is now mired in the second worst drawdown since 1990 > SEE MORE
In a June 1999 interview with Businessweek, Warren Buffett is quoted as saying, “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”
Michael Mauboussin, director of research at BlueMountain Capital Management (and prior to that, head of global financial strategies at Credit Suisse and chief investment strategist at Legg Mason Capital Management), seems to agree with Buffett. In his book, “More Than You Know,” Mauboussin wrote: “Investment philosophy is really about temperament, not raw intelligence. In fact, a proper temperament will beat high IQ all day long.”
Temperament is critical to successful investing because markets persistently test investor discipline with periods, often long ones, of volatile and/or poor performance. In my more than 20 years of > SEE MORE