The case for diversifying outside the U.S.

The average advisor portfolio allocates 19% of its equities to stocks outside the U.S.,¹ despite 84% of the world’s economic activity² and 65% of public companies with market caps over $5 billion being located internationally.³ Moreover, over the past decade, 82% of the highest-performing stocks annually originated from outside the U.S.⁴ Yet over the same period, the strategy of underweighting non-U.S. stocks has proven to be among the most effective asset allocation choices.

As such, advisors naturally may be skeptical of considering an approach that does not substantially overweight U.S. equities. But that may need to change. In fact, going forward, we see several reasons for advisors to consider bulking up the foreign stock holdings in their portfolios, and offer three tips for how to choose the right international equity fund for their clients.

The case for non-U.S. equities

Foremost is the existence of exceptional companies beyond U.S. borders. As illustrated in Exhibit 1, international markets have recently presented numerous attractive growth opportunities. In today’s environment, where the cost of capital is higher, we believe many non-U.S. domiciled companies look especially attractive thanks to strong and reliable cash flows, valuations relative to earnings visibility, and the capability to finance growth internally.

Aesop, the ancient Greek storyteller, once remarked, “It is possible to have too much of a good thing.” Currently, many advisor portfolios are overly concentrated in the high-flying tech stocks known as the Magnificent 7, overlooking the extensive growth opportunities available globally.

The second reason stems from a notable uptick in Manufacturing Purchasing Managers’ Indices (PMIs) since mid-2023. Leading indicators, including the ratio of new orders to inventories, have hinted at a sustained improvement in Manufacturing PMIs. Typically, as Manufacturing PMIs rise, international equities tend to surpass U.S. equities in performance, owing to their cyclical nature. Although recent PMI figures have been mixed, they are not sufficiently negative to detract from the anticipated upward trajectory that we expect to persist.⁵

The third reason revolves around a familiar topic: valuation. The growing disparity in multiples between the U.S. and other parts of the world is often attributed to differences in benchmark composition. For instance, the information technology sector constitutes about 32% of the S&P 500 today in contrast to just 14% of the ACWI ex U.S. This disparity has significantly influenced index-level compound annual earnings growth, which has been notably higher for the S&P.

We contend that this comparison, based solely on sector composition, is not entirely sufficient. When conducting a sector-neutral analysis of price-to-earnings ratios, the rest of the world still appears to trade at a discount. The sustainability of this divergence in multiples remains to be seen over time.

It’s important to highlight that the strength of the dollar has posed a considerable challenge for U.S.-based investors allocating assets internationally since 2011. Should the dollar cease its strengthening trend or begin to weaken – potentially as a result of the Federal Reserve moving toward rate cuts – this shift could serve as a significant catalyst for non-U.S. markets.

Many might find it surprising that, when the effects of currency fluctuations are excluded over the past three years, the MSCI EAFE currency-hedged index has actually outperformed the S&P 500 by nearly 1% annually.

How to allocate effectively in international markets

After deciding to invest in stocks outside the U.S., the next crucial step involves determining the most effective allocation strategy. A common initial consideration for most allocators is whether to opt for active or passive management. Although this decision might be influenced by personal biases or convictions, historical data indicate that active management has generally achieved greater success in surpassing benchmarks compared to other markets. For instance, over the last decade, 64% of actively managed international funds have outperformed their respective benchmarks (Exhibit 5).

One common misstep that our team has observed involves portfolios incorporating international funds that fail to provide comprehensive diversification. While it’s true that the correlation between international and U.S. stocks has increased over recent decades due to the global expansion of companies, certain investment styles and categories still offer more diversification benefits than others. This point is not meant to advocate for any specific investment style; instead, it’s a call to action to ensure that your international investments genuinely enhance your portfolio by offering a distinct risk and return profile.

We frequently encounter international funds that hold significant U.S. assets or have concentrated exposures to economic growth drivers similar to those of U.S. large caps, which usually play the biggest role in determining the risk and return dynamics of portfolios.

As we delve into the nuances of international investing, understanding the “why” and “how” sets the stage for addressing the crucial question of “who.” Selecting the right manager is more of an art than a science. While no strategy is foolproof, the following three tips can enhance your chances of choosing a manager who aligns with your investment goals:

Rolling success rates: Allocators often rely on static trailing returns when selecting funds, which can introduce significant biases related to specific starting and ending points. A more comprehensive approach involves examining a fund’s net results over various rolling time periods. This method offers a fuller picture of performance. Equally important is verifying that the current management team is responsible for the fund’s track record, ensuring continuity in decision-making and strategy.

Repeatable process: For actively managed equity portfolios aiming for consistent excess returns, it’s vital to have established sound methodologies and processes. Understanding how a manager achieves his or her results is key to building confidence in your choice and minimizing unnecessary turnover. We advocate for managers who take a disciplined approach to security selection, underpinned by thorough fundamental research, a focus on free-cash-flow growth, and the pursuit of unique insights, which we believe can yield superior risk-adjusted returns.

Prudent risk management: One of the primary goals for equity portfolio managers is to mitigate systemic market risks while showcasing their prowess in security selection. Familiarizing yourself with a manager’s risk budgeting guidelines and conducting risk attribution analysis can reveal managers who employ a thoughtful approach to portfolio construction. The aim is to identify those compensated for their skills in selecting securities rather than for taking diversifiable factor risks.

With these tips in mind, we believe you can improve your ability to select a manager who not only possesses the expertise to navigate the complexities of international markets but also aligns with your investment philosophy and objectives.

IMPORTANT INFORMATION

Active and passive investments may both lose value when valuations fall and market and economic conditions change.