Jack Bogle may have contributed more to the investment management industry than any other human in history. Mr. Bogle is the founder of Vanguard, the largest mutual fund company in the world, and innovator who came up with the idea of the shareholders owning the funds they invest in. Because of this structure (no shareholders who are demanding profits), they are able to keep their fees exceptionally low, which is one of the reason we use them for our clients. They are also the fund company that popularized index funds, espousing the idea that owning the entire market passively is a much better bet than trying to pick winning stocks. Low fees, broad diversification…what's not to like?
In listening to a recent interview with Mr. Bogle, I found myself agreeing with almost everything he said. Almost everything. When the interviewer asked Bogle about investing outside the US he argued against it, claiming excessive risk and lack of returns. Here are his comments when asked about investing in an international index fund (that his company provides!):
"So if people knew they were putting 45% of their so-called international, non-US, money in Great Britain, France and Japan — I mean every one of those three countries has real problems," Bogle said.
"The French don’t work very hard, The Japanese have a structured and deeply aging economy overburdened by future retirement claims… Britain doesn’t know what’s going to happen if they do the exit from the European community, nor do they know what’s going to happen if they stay in."
Seems like a logical argument. The heaviest weightings in the international index have real problems. Why would you want to invest in them?
Here is the issue. It flies in the face of the very theory he is promoting at Vanguard! When you invest in index funds you are taking the stance that markets are efficient so it is pointless to try to outguess it by picking stocks. The data totally backs up Vanguard's claim on the merits of index funds, by the way. So when Bogle states all the reasons why international stocks won't perform as well as US stocks, he is basically saying that the market is inefficient. You see, he is probably right when he states all the problems with France, Japan and Great Britain, but what he doesn't seem to understand is that the market knows exactly what he knows (probably more). If that is the case, the market should be pricing in that lower growth in the form of cheaper stock prices. In fact, the market is doing exactly that. According to Henderson Global Investors, the Price-to-Earnings Ratio (which is a measure of how expensive a stock is) in 2016 for the US is 17 while in Japan and Europe it is 14.
Let me even do a little thought experiment using Japan. Let's say tomorrow morning you wake up to the headline that Japan has had a massive census error and instead of their population being older than every other developed nation, that it is in fact the opposite. There is a huge generation of working aged Japanese that were unaccounted for. In addition, their massive debt has really been an accounting error. In fact, they have been in the black for years and in fact have surpluses (I know it seems crazy, but bear with me). What do you think would happen to their stock market when it opened for trading? My guess is that it would go up…probably a lot. Why? Because the market would adjust to the new reality that Japan is not as bad as originally thought. If you believe that statement, then you also have inadvertently believed that the market is efficient. It is pricing Japanese stocks today at a level much lower than it otherwise would, to account for all the problems in the Japanese economy.
This explains the simple truth that "the stock market is not the economy" (it is actually very funny to look at the chart on this post since it comes from Vanguard!). Trying to claim, like Bogle, that the stock market's performance will be the same as the country's performance is just not backed by any evidence. The US economy could do significantly better than Japan over the next 10 years and their stock markets could do the exact opposite. All that matters with the stock market is expectations. If Japan beats very low expectations, they could easily do better than the US (who has very high expectations).
So to circle back on the original question- Greenspring respectfully disagrees with Mr. Bogle. We believe that investors should have an allocation of their portfolio to foreign stocks. We have found they add diversification value (as evidenced here, here and here) which for many investors is key to smooth out their returns.
One of the arguments I have heard over the last several years is whether investors truly need global diversification. The argument goes like this: nearly 50% of the revenue from the S&P 500 comes from overseas, so aren't I getting diversification to other countries by owning the S&P 500 since globalization is just so much more prevalent these days? It is not surprising that this argument has surfaced after 5 years of significant outperformance from the US stock market over both foreign developed stocks and emerging markets. Investors tend to make arguments suggesting why a simple investing theme no longer applies AFTER it has been out of favor (think about the late 1990s when many argued that earnings didn't really matter anymore).
Nevertheless, it is an interesting thesis and to some extent is correct. Things are more global these days. Multinational companies sell all over the world. But recent research from Credit Suisse (via ETF.com) suggest that global diversification is still valuable for another reason:
just as industries can be concentrated within a few countries, so countries can be dominated by a handful of industries.” For example, “the weighting of the three largest industries accounts for at least 40% of country capitalization for 42 out of the 47 countries; for at least 50% for 33 countries; for at least 60% for 21 countries; and for 70% or more in 15 countries.
While the US is much more diversified across industries than other countries, we still have our overweights:
The U.S. is among the countries least concentrated by industry, but we still have “a heavy weighting in technology (17%), high weightings in oil and gas, health care and consumer services, and lower weightings in basic materials, consumer goods and telecoms.”
Some countries just tend to be more focused on specific industries either due to natural resources, country demographics, education, or history. Focusing your portfolio on one country (or handful of countries) may be targeting a smaller group of industries that could have been available to you had you invested in a global portfolio. While a home country bias probably makes sense for most investors, that doesn't mean you should ignore the rest of the world.
As we continue in our series on "Shrinking The Gap", we are going to focus on another positive contributor to performance: exposure to risk factors. Extensive research has been performed to determine what specific factors have a meaningful impact on both risk and return. For purposes of this post, we are going to focus on the two that we believe are the most persistent:
- Size factor- small companies outperform large companies
- Value factor- value companies outperform growth companies
In 1992, Nobel prize winner Gene Fama and Ken French release groundbreaking research on this topic. Their findings were significant and have sparked an entire industry of "factor investing" or "smart beta" strategies. The firm best embracing this concept (and finding the most success) has been Dimensional Fund Advisors. A chart of the Fama/French research can be found below:
What their research has proved is that small companies and value companies have generated BOTH higher returns and higher risk for investors. This is true not only in the US, but in other free market economies they were able to obtain data from. So what does this mean for investors? First, those who are willing to accept elevated risk levels are able to generate higher returns by tilting their portfolios towards these factors. This is one way an investor can "close the gap" between their actual return and the market's return. Second, rather than focusing things that don't matter (which fund is going to outperform, is the market high, which stock should I buy), investors now can concentrate their efforts on factors that will have a real impact on their portfolio's performance.
If you have been holding a diversified portfolio, it's been a frustrating few years. Nothing outside of US stocks has been working. We have been counseling clients that sticking with their original plan of global diversification still makes a lot of sense since the tides will turn eventually. We may be seeing those shifts sooner than we thought. Below is a chart of showing the first month of the year:
Although a short time period, things have shifted in 2015. After a month, the US stock market (black line) is the clear loser when compared to the developed foreign markets (gold line) and the emerging markets (blue line). For the past five years, US stocks have gone up over 15% per year, while foreign developed stocks are up 5% and emerging market stocks are up 2% per year. It is not hard to understand why people might abandon diversification and just decide to stick with the US markets. The problem is that trends don't last forever. At some point the tides will change. This is not dissimilar from the 1990s. This decade was a great period for the US stock market with substantial economic growth ending with the technology boom. The US stock market had tremendous gains and outperformed almost every other asset class. Those choosing to concentrate their assets in large US companies at the end of this decade, because of that great performance, found that the next 10 years were horrific (taken from the Irrelevant Investor Blog):
Investors need to remember that if you are properly diversified, there two truths that you ALWAYS have to live with:
- You will always have something to complain about- something in your portfolio will be out of favor every year if you are properly diversified.
- You will never outperform the best asset class- in fact your portfolio will always fall somewhere in the middle of the asset classes you are invested in. In the case of 2014, if you have adopted a diversified portfolio, you should be upset you underperformed the S&P 500. It was one of the best performers
The upside of all of this is that your portfolio will never be as bad as the worst asset class in the portfolio, you don't have to try to "guess" which asset class to rotate into each year, and your returns will be much less volatile. We believe that this is a worthwhile tradeoff.
Yesterday, we wrote about the value of adding foreign stocks to a portfolio. The next question we wanted to answer was how much of your portfolio should be in foreign stocks. Unfortunately, there isn’t a right answer to the question. It is probably more art that science, but we do think there are some key points investors should be aware of.
- The US Market represents about 40% of the total market capitalization of the world. This is a good starting point to determine how much of your portfolio should be in US versus foreign stocks.
- Our own research shows that adding foreign stocks to an all US stock portfolio brings down the risk of the total portfolio, so we recommend that most clients have at least 30% of their equities in foreign stocks
If the US market makes up 40% of the total world stock market, why would we advocate having 60 or 70% of our client’s portfolio in US equities? There is good reason for this “home country bias” that investors should consider when designing their portfolio:
- Fees for US equity funds are less than foreign equity funds. According to Morningstar, the average expense of a US Large Blend Fund is 0.48%, Foreign Large Blend is 0.74% and Emerging Markets is 1.10%.
- Trading costs are lower. One study found that trading costs for US Equity funds averaged 0.36%, Foreign funds 0.45% and Emerging market funds were 0.61%.
- Behavioral- when investors significantly weight foreign stocks in a portfolio there can be more of a tendency to tweak the portfolio over time since there will be many years with significant underperformance to indices like the S&P 500. Since most of us tend to compare our portfolio to the market we see on TV or on the internet (like the Dow Jones or S&P 500), we must ask ourselves the question whether we would feel comfortable significantly trailing the US market during some years. I have found that the more a client deviates from their perceived “home market” the higher the possibility for tinkering with the portfolio.
For all these reasons, most clients would be well served by keeping a larger portion of their equities in US stocks.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.