Regular readers will know that I’ve been singing the benefits of diversifying away from US equities in favor of international equity allocations for quite a long time.
The S&P 500’s gains in the years following the credit crisis have been astonishing and undoubtedly dwarf those found anywhere else in the world. However, that means that there is very little value left, and with growth expectations on the up throughout the developed world, there is a very good chance that outperformance will have to be found outside the States.
The other reason to favor international portfolios is that despite the weaker dollar in 2017, the dollar index – which tracks the value of the dollar against a basket of developed currencies – is still sitting well above its typical range and is trading close to a 15-year high. While the value of the dollar is being supported by the Federal Reserve’s tapering and planned rate rises, it’s still tough to argue that it’s not overvalued on a long-term basis.
I was heartened to see that I’m not alone in this view at our recent event in Los Angeles. Increasing allocations to international equities turned out to be one of the top items on pro buyers’ agendas for the coming months.
International equities are still dominated by active products too, with $1.5 trillion of assets in large- and multi-cap active funds, versus $624 billion in exchange-traded funds (ETFs). However, as with all parts of the active market, this picture is changing. Over the past 12 months there have been net inflows of $70 billion into ETFs, versus an outflow of $8 billion from active funds.
This is a shame, as it has undoubtedly been a better year for active products worldwide, with fundamentals regaining importance. In recent years, international peer groups’ outperformance rates have held up well. Multi-cap core, which is by far the dominant category with $650 billion in assets under management, has an average of 45% of managers outperforming over one year, and 46% adding value over three and five years. That number rises to 67% over the past seven years. Of course, survivorship bias is prevalent in those numbers, but they are a long way above the competition in domestic sectors over what has been a tough period for all active equity managers – not just those trying to beat the S&P.
Choose your destination
Assuming you go active, what are you buying? On average, portfolio managers are largely underweight Japan, with a 16.7% allocation versus the 24.1% it occupies in the MSCI EAFE index. Given Japanese prime minister Shinzo Abe’s grip on power and the seemingly progressive reforms he is initiating, this underweight may be a reason to favor the passive route. However we are talking about a domestic equity market that has risen by 45% over the past 16 months, so prudence might not necessarily be a bad thing.
Portfolio managers are also underweight the UK – a 12.9% allocation versus 17.5% in the index. Given the risk that Brexit poses to the county’s economy, this seems wise. Those underweights have been typically used to invest in off-benchmark positions in emerging markets, with China (4%), South Korea (2.8%), India (2.5%), Taiwan (2.2%) and Brazil (1.7%) all featuring among the top 20 countries in active portfolios. China and South Korea also feature as part of the main plays on technology, with Alibaba, Tencent and Samsung regularly appearing in top 10 holdings – particularly among those portfolios that have added the most value in recent years.
Most managers are also fully invested, with an average cash pile of just 1% of assets.
When it comes to currency, active investors are still getting healthy exposure to the euro (27.4%), the Japanese yen (16.8%) and the weak pound sterling (13.7%). You will also note that some managers have chosen to hedge some or all of their holdings back to the dollar, which results in an average allocation of 12.8% to the greenback.
To my mind, though, if you are hedging out the currency you are missing out on the potential for these currencies to rerate. The good news is that these are the exceptions and not the rule: only 10% of the funds we track have more than a third of their currency exposure in the dollar.