Why Bother With International Markets?
U.S. stocks are up 15.34% so far in 2021, outpacing non-U.S. developed market returns of 9.65% by a fair margin and trumping emerging markets’ -0.99% return by more than 16 percentage points. This phenomenon is not isolated to the most recent nine months. As is illustrated in Figure 1, annualized returns for the U.S. stocks have been more than double their non-U.S. developed and emerging market counterparts over the last 10 years. Over 20 years, emerging markets led the way, followed by the U.S. and then non-U.S. developed markets.
Figure 1 | U.S. Stocks Have Been the Clear Winners Lately
Data as of 9/30/2021. Source: Morningstar. Past performance is no guarantee of future results.
Diversification is a common word in investing. Whether referring to individual stock positions, sectors, industries, asset classes, or regions, the logic is similar. By spreading your investments among more components, your returns become less reliant on any single investment, thereby reducing the “idiosyncratic” (i.e., diversifiable) risk in your portfolio. It is a beautiful concept today with so many applications, just as it was so many decades ago when Professor Harry Markowitz introduced the concept of relating risk and return in portfolios.
We can observe the concept simply in Figure 1. The bottom row—bolded for emphasis—is the All Country World Index (ACWI) and includes the U.S., non-U.S. developed markets and emerging markets. You can see that the MSCI ACWI’s return is never the highest nor the lowest. By diversifying, you may sacrifice some potential upside, but at the same time you can also avoid some potential downside. That is diversification in a nutshell.
Hindsight May Be 20-20, But Driving While Staring in the Rear-View Mirror Is Dangerous
So, what happens when diversification doesn’t “work”? Here, it is important to clarify what “work” really means. In the case of investing internationally, we are often susceptible to examining the global portfolio relative to U.S. stocks. For example, it is very easy to look at Figure 1 and wonder why one would have invested outside the U.S. at all over the last 20 years. There are hundreds of companies in the US Index –more than enough to build a well-diversified portfolio under Markowitz’s portfolio theory. That diversified U.S. index beat the diversified global index, so why was it prudent to maintain an allocation outside the U.S.?
After the fact, it could be easy to say that. It is worth pointing out though, that under that logic one could argue that the smartest strategy would have been to be 100% in emerging markets. After all, the diversified emerging markets index beat the diversified global index and the diversified U.S. index over the last 20 years.
After the fact is the key phrase here. One column, four numbers, one decision. If you could have made that call a couple of decades ago and not looked at your portfolio in between, that could have been the outcome.
A Closer Look
But what if we dig a little deeper? In Figure 2, we plot calendar year returns for U.S. (MSCI USA Index), non-U.S. developed markets (MSCI World ex-USA Index) and emerging markets (MSCI Emerging Markets Index) since 1999. Immediately, we can see that an investment in any of these regions would have had its ups and downs. In emerging markets, annual returns range from almost 79% on the high end to -53% on the low end. For U.S. and non-U.S. developed markets, the ranges are slightly narrower. As we move left to right across the chart, we can also pick out multi-year stretches where U.S. markets lag non-U.S. developed or emerging markets, and vice versa. Concentrating in just one of these regions while it lagged the others may not have been so straightforward in the moment.
Figure 2 | Long-Term Returns Are Made Up of Short-Term Returns
Data from 1999-2020. Non-U.S. developed markets are represented by MSCI World ex-USA Index. U.S. is represented by MSCI USA Index. Emerging Markets are represented by MSCI Emerging Markets Index. Source: Morningstar.
We can take this exercise a step further. Rather than just look at the regions, what if we had to compare our returns to individual countries in non-U.S. developed and emerging markets year by year?
In Figure 3, we add the best and worst country return for each year to our original illustration in Figure 2. While the spread between regional returns may have seemed large, it pales in comparison to spreads in country returns. A strategy that was able to identify the best country in advance each year would have often seen gains of 100% or more, while concentrating an investment in the worst performing countries would have been catastrophic for a portfolio.
Figure 3 | There's Almost Always a Better (or Worse) Place to Have Been
Data from 1999-2020. Non-U.S. developed markets are represented by MSCI World ex-USA Index. U.S. is represented by MSCI USA Index. Emerging Markets are represented by MSCI Emerging Markets Index. Best and worst countries are represented by MSCI country indices. Source: Morningstar.
Now, Figure 3 just shows the best and worst country return globally, and that selection alone would be challenging enough. To provide context around the difficulty of selecting the best country within each region every year, we list the best-and worst-performing developed and emerging market country from 1999-2020 in Figure 4.
Figure 4 | Pick a Country, Any Country
Data from 1999-2020. Countries are represented by their respective MSCI country index. Source: Morningstar.
Notice any discernible pattern? Even with color coding, it is difficult to notice any consistencies. In fact, the only consistency appears to be the randomness of which country performed best each year. For example, in emerging markets, there are 16 different best performers over the 21 years included in the sample. In developed markets, there are 12 different best performers over the 21 years.
If we return to Figure 3, the non-U.S. developed and emerging market region returns fall between the best and worst country returns. Investors didn’t need to identify the best-performing country each year to achieve the returns of the overall region. Investors who diversified across countries similar to the regional index would have been able to capture the market-cap weighted returns of all the countries in the regions. That is diversification at work.
So Why Bother?
Does that mean the global market portfolio is the right choice for everyone? Surely not. There are many reasons, such as taxation, costs, etc., why an investor may be better served by a different allocation. But the fact that international markets have recently lagged U.S. markets has no bearing on whether they will continue to lag.
In hindsight, it can be easy to critique past investment decisions and scold ourselves for not having “known better.” As investors, we should be careful not to infer that it means we can predict what could happen next.
MSCI ACWI (All Country World Index) Index. A free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets.
MSCI country indices. Designed to measure the performance of the large- and mid-cap segments of each country's market.
MSCI Emerging Markets Index. A free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
MSCI USA Index. Designed to measure the performance of the large and mid cap segments of the US market. With 602 constituents, the index covers approximately 84% of the free float-adjusted market capitalization in the US.
MSCI World ex-USA Index. A free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.