Home country bias?
Most investment advisers, including UBS, recommend that investors hold globally diversified equity portfolios. However, the sustained outperformance of US equities over the last eight years has challenged that view and many of the investors we work with are pushing back against global diversification.
This month, we take a deep dive into global equity portfolio performance, hypothesize that there’s a behavioral finance reason strategists and investors disagree when it comes to non-US equities, and discuss two specific reasons retirees should keep some non-US exposure in their portfolios.
Although this report has been written with a US audience in mind, we hope our readers in other parts of the world also find the general themes instructive in thinking about their own home-country bias.
Unless otherwise indicated, all performance data is presented in USD.
What do 48 years of data tell us about global equity portfolios?
Since 1970 (the earliest data we have available), we have had four major cycles in US versus non-US equity performance: 19701988, 1989-2001, 2002-2009, and 2010-2017. Over that extended period, and with significant caveats, US equities have outperformed a global portfolio (one that includes US equities, non-US developed equities, and emerging markets equities), but average annual returns have not been statistically different.
We focus on analyzing global equity portfolio performance instead of international equity performance because most US investors are selecting between holding a US portfolio and a global portfolio, not a US-only portfolio and an non-US portfolio.
Do US equity portfolios really outperform global equity portfolios?
• Statistically speaking, US equity portfolio and global equity portfolios have performed similarly over the last 48 years.
• Over 48 years, US equities have outperformed a global portfolio 51 percent of the time on a calendar year basis, meaning that the frequency of outperformance has also been roughly equal.
• Investors should expect decade-plus periods of alternating leadership by global and US portfolios
What about risk and volatility? Equities are equities:
• Investors shouldn’t expect meaningful volatility reduction from adding international equities to a US equity portfolio.
• In fact, global equity portfolios have historically been slightly more volatile than US-only portfolios over the last 48 years
The bottom line: We don’t believe US equities structurally offer better returns over long periods than global portfolios, but long periods of relative outperformance or underperformance are not uncommon.
Do international equities play an important role for retirees?
Over the very long run (multiple market cycles), global equity portfolios and US equity portfolios will likely have similar returns. Unfortunately, as John Maynard Keynes pointed out, “over the long run we are all dead.” Our task, which is to manage portfolios effectively through the next cycle, requires considering the risks and opportunities that could derail or enhance our ability to meet our objectives.
We expect better returns from non-US equities than US equities over the next part of the cycle. Why do we have that view?
• The earnings boost from US tax cut is fading.
• The US economic cycle is further along than most other regions.
• Emerging markets trade at an 18 percent discount to their long-term average, whereas US equities trade at an 18 percent premium. Valuations in the technology sector, which has created a large portion of US outperformance, appear particularly stretched.
There’s also a specific portfolio risk that non-US equities can be useful for hedging: inflation. Domestic inflation generally leads to currency depreciation. In environments with higher-than expected inflationary pressures, the foreign currency exposure inherent in non-US equity allocations can help hedge against losses of purchasing power.
The 1970s are a good example of such a period.
Inflation averaged 7.25 percent between 1970 and 1979, and the dollar declined by 30 percent over the decade. Non-US equities returned an average of 11 percent per year, whereas US equities averaged 6 percent per year. Net of inflation, non-US equities actually appreciated in value, but US equities lost over 10 percent of their purchasing power during the decade.
We do not expect a repeat of the 1970s, but non-US exposure adds some peace of mind to hedging the (potentially inflationary) fiscal and monetary risks we face in the US.