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Global Flexibility is Important in Constructing Equity Portfolios

By Sunder Ramkumar
Senior Vice President, Client Analytics

By Michelle Black
Head of Wealth Advisory

Globalization is having a significant impact on the universe of investment opportunities, as many companies headquartered in Europe, Japan and the United States no longer generate the bulk of their revenue in their home countries.

In our view, this change forces a re-evaluation of whether investment portfolios should be built along strict regional lines or a corporation’s place of domicile.

International investing has traditionally been seen as a source of diversification and risk mitigation for U.S. investors. But over the last 20 years, correlations have become less differentiated between U.S. and non-U.S. equities, and this development is challenging previously held notions about the role of international equities in portfolio construction.

For example, the monthly correlation between the S&P 500 Index for U.S. equities and the MSCI EAFE Index for non-U.S. equities was only 0.48 from 1970 to 1996. However, as global equity markets have become increasingly interconnected, correlations have steadily inched up since the mid-1990s. In fact, monthly correlations have almost doubled to 0.84 over the last 20 years.

The changing pattern of global equity correlations has important implications.

Historically, U.S. investors could simply reduce risk by allocating a slice of their portfolios to companies based outside the U.S. For example, a portfolio with 40% non-US equities had approximately 1.5% lower volatility than one with all U.S. equities, and lower losses in down months.

That dynamic has greatly weakened as correlations have increased. Over the last 20 years, portfolios with allocations to international equities have had similar, and often higher, volatility.

This does not mean that investors should forget international investments altogether.

Instead, they should re-think their approach to global investing. As diversification and risk benefits have become less pronounced, international equities present opportunities for stock pickers to pursue broader investment opportunities by homing in on individual companies.

History Shows Companies Can Transcend Indexes

While market-weighted indexes are good barometers for aggregate results, they can mask opportunities at the company level.

Over the last 10 years, U.S. equities have staged a massive run to trade at record highs, with the S&P 500 besting the MSCI EAFE Index by an annual average of more than 5.3 percentage points.(MSCI EAFE tracks large and mid-cap stocks in 21 developed markets, excluding U.S. and Canada).

But this doesn’t tell the whole story.

We examined equity returns during this 10-year period, breaking down the results of 10 sectors in the MSCI World Index, which is a gauge of stocks in 23 developed markets. For each year, we selected the five top gainers by sector for a total sample size of 50 stocks.

The result: On average, close to 60% of the top-returning companies were domiciled outside the United States. In 2010, for instance, U.S. equity markets produced almost double the return of their non-U.S. counterparts — yet more than two-thirds of the best-returning stocks were those of foreign companies.

This illustrates how international equities can increase investment opportunities for skillful managers, while presenting a challenge for investment decisions that are made purely along rigid geographic lines.

In constructing an equity portfolio, the ability to break free of regional borders and the capacity to implement a flexible approach in terms of asset allocation can be beneficial. It will open the door to a wider pool of companies that otherwise may be constrained by a country-level bias.

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Sunder Ramkumar has 13 years of investment experience, two with Capital Group. He researches asset allocation and investment strategies. He holds an MS in management science and engineering from Stanford.

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Michelle Black has 22 years of investment experience, 16 with Capital. She leads the Wealth Advisory Group, which helps clients build portfolios as well as other financial planning strategies.