Is Diversification Killing Your Portfolio?

What if I told you that investing outside of the U.S. over the last decade has done nothing but hurt your portfolio returns? It’s a broad statement, but from a high level and looking at international stocks as an asset class and in aggregate, it’s true. Investors tend to overweight and over allocate to stocks and geographies they are familiar with, an effect referred to as “familiarity bias”. For investors in the United States, that effect has been a winning wager over the last decade. Below you can see price returns for the S&P 500, which measures the largest 500 U.S. companies and the MSCI ACWI ex US which is an aggregate measure of global stocks outside of the U.S.

Since 2009, the S&P 500 has returned nearly 399% vs 130% for the ACWI ex U.S. And as a matter of fact, the international index still has not reached the levels seen in 2007. Over a decade of no price return. For those over-allocating to international companies during that period, that stings.

So, what gives? Are U.S. companies just ahead of everyone else? Said another way, when you look at what type of companies have done well over the last decade, technology, consumer discretionary and communication services immediately come to mind. Can you think of a major technology or communication services company headquartered outside of the U.S.? There aren’t many. The composition of international indexes largely comes from energy, financial and consumer staples companies. With the price of oil at a multi-decade low, negative interest rates across Europe, and demographic challenges in Asia these companies have not had the type of growth compared to those headquartered in the United States.

Now, does that mean you shouldn’t invest internationally? Of course not. The principles of diversification still apply. 40% of the world’s market capitalization is outside of the United States. Factors such as currency and legislative risk all still exist, and good risk management starts with acknowledging such risk and embracing diversification. There are companies that will do well internationally and outpace their counterparts in the United States, and some of these dynamics that have held growth back over the last 10 years may revert. That said, the composition of your index matters. What tool you use to invest in international companies will greatly affect how this exposure will perform within your portfolio. What you cannot see on the previous chart, is the small pockets of international stocks and sectors that did perform quite well over the last decade. Will the aggregate growth of international companies outpace that of the U.S. over the next decade? We’ll see. That debate is for another blog.

We put a lot of research into understanding how various indices are constructed, and what type of sector allocations that creates. Just broadly allocating to “international” stocks can lead you to some unpleasant results. Overweight international financial stocks with negative interest rates across Europe has not panned out well over the last decade. We remain underweight international stocks. The sector composition of each countries stock market index is the largest driver of risk and return. If you are unintentionally underweighting the international sectors that are growing buy just buying a certain countries fund, you may have the wrong tool. We are constantly examining our portfolios to ensure we are using the right tool for the job, and what type of geographic and sector allocation we are making. Diversification is important. But equally as important is understanding the ingredients in your international allocation’s recipe.

The views are those of Robert Jeter and Eric Johnston and should not be construed as specific investment advice. Investors cannot directly invest in indices. Past performance is not a guarantee of future results.
Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.
Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards.
Investment Advisor Representative offering securities and advisory services offered through Cetera Advisors LLC, member FINRA/SIPC, a broker dealer and a Registered Investment Adviser. Cetera is under separate ownership from any other named entity.