The Importance of International Diversification in Your Portfolio
Miao Yu, CFA | February 23, 2021
This question is one we hear a lot from clients: “Why do I want to hold non-US equities in my portfolio? I know more about US companies and feel more confident about their performance over international equities.”
It goes without saying that the US is home to some of the most successful companies in the world: Apple, Microsoft, Amazon, Google, Facebook, Berkshire Hathaway, to name just a few. The holdings for the top ten US companies have experienced an average annualized return of 25% over the last 11 years, while the S&P 500 has seen an annualized return of 13%.
These top ten holdings account for 27% of the S&P 500 index, the S&P 500 accounts for 82% of the US broad market Russell 3000 index, and the Russell 3000 accounts for 98% of the total US market. These statistics show us why it’s safe to say the US market has been so strong and why the last 11 years of high returns can be attributed to mega cap stocks. (Source: author’s calculations.)
Although the US has outperformed International Developed and Emerging Markets over the last decade, we are strong supporters of international diversification. This is primarily due to international and emerging markets valuations being substantially lower than the US based on their respective CAPE ratios. The CAPE ratio, Cyclically Adjusted PE ratio, is also known as the Shiller P/E ratio. It is a measure of price divided by an average of the past 10-year earnings, all adjusted for inflation. The higher the ratio, the higher valuation is. The CAPE ratios as of January 2021 are:
- US large cap (S&P 500): 33.7
- International Developed (MSCI World ex-US): 18.2
- Emerging Markets (MSCI Emerging Markets): 16.7
The S&P 500 is in a historically high valuation. Currently, it is just a little bit lower than the 2000 tech bubble, while International Developed and Emerging Markets are in a historically lower valuation region.
Even though we may see US large cap with an even higher valuation in the next decade, we think there is a lot of opportunity for the international markets to increase. These two charts illustrate what we have seen historically with US and International Developed markets:
International Developed (MSCI World ex-US) vs. US Large Cap (S&P 500)
Emerging Markets (MSCI EM) vs. US Large Cap (S&P 500)
Looking Back at International Market Performance
We don’t know what to expect in the next decade and when we look back for insight, the only thing we see is that every decade tells a different story. In the last 30 years we have seen a different outcome for each market. I am assuming you can easily guess in what decades the US yielded the highest and lowest annual returns, but what you may not know is how the international markets performed in the past. Let’s take a look:
2010 – 2019
Over the last 10 years the annual return has been:
- US: 13.48%
- International Developed: 4.37%
- Emerging Markets: 2.50%
All we can say here, is that the last decade was spectacular for the US when compared to the likes of Emerging Markets and International Developed.
2000 – 2009
Ten years prior, it was a very different outcome – Emerging Markets led the way, International Developed and the US performed poorly. Let’s take a look at the annual returns during this time span:
- US: -0.95%
- International Developed: 1.62%
- Emerging Markets: 9.78%
1990 – 1999
In the 90’s we saw the US lead the way once again, followed by Emerging Markets and International Developed. This chart shows us the importance of a globally diversified portfolio. Even though the US finished the strongest in the 90’s, early on Emerging Markets was outperforming – illustrating the need for exposure to US and international markets.
- US: 18.21%
- International Developed: 7.10%
- Emerging Markets: 11.04%
Maintain a Globally Diversified Portfolio
We don’t have a crystal ball, which means there is no way of knowing what market will provide the best return in the next decade. With that in mind, your portfolio should include exposure to US and international markets. We believe a globally diversified portfolio can help alleviate volatility in your portfolio. Given higher US valuation multiples, we are in favor of continued International Developed and Emerging Market diversification. If you have questions about your portfolio, we’d enjoy speaking with you.
You can schedule time for a discussion HERE.