Global diversification has disappointed; don’t give up on it

THE conventional wisdom in investing insists people should overcome their home bias and invest globally. There are great businesses around the world, the thinking goes, and investors benefit by looking beyond their borders. But this idea is now being tested as never before, particularly among US investors.

The reason: For almost a generation, US public and private equities have thumped their overseas counterparts. Young investors in their 20s and 30s may not even recall a time when the US did not dominate global markets.

The results of the past 15 years are astounding.

Since 2010, the S&P 500 index has returned 13.3 per cent a year, including dividends, while the MSCI EAFE Index, a collection of companies in developed countries outside the US, has returned less than half that, offering up only 5.9 per cent a year. The MSCI Emerging Markets Index performed even worse, eking out 3.2 per cent annually.

Private US equities performed as well as public ones, with Cambridge Associates’ private equity and venture capital (VC) indexes posting returns of 14.1 per cent and 13.1 per cent a year, respectively, over 15 years through September 2023.

With results such as these, why bother investing outside the US? If Vanguard Group founder John Bogle were alive, he would undoubtedly tell US investors that they should not.

Bogle insisted that multinational US companies already provide investors with sufficient exposure to overseas markets. He said he never understood the need for a global portfolio. “Maybe it’s right, of course – maybe anything is right,” he said in an interview with the fund researcher Morningstar. “But I think the argument favours the domestic US portfolio.”

Warren Buffett has also long steered investors to the S&P 500, despite his own investments in Europe and Asia. That turned out to be good advice, but the US’ dominance since 2010 was far from inevitable.

In fact, a closer look at how it happened and global equities’ longer track record suggests that the past 15 years may be the exception rather than the rule. Allow me to make a contrarian case – in favour of conventional wisdom.

As is often the case with stocks, the story of the past 15 years starts with earnings, and profits provided most of the fuel. S&P 500 earnings took off in 2010, growing 14.1 per cent a year through April, and far outpacing the earnings growth of 10.6 per cent for developed international stocks and 2.9 per cent in emerging markets.

Valuation contraction also played a part. The price-to-earnings (PE) ratios of all three groups have contracted since 2010, a hangover from a spike in PE ratios when earnings collapsed during the 2008 financial crisis.

But, developed international markets were hit particularly hard. The EAFE’s (Europe, Australasia and Far East) PE ratio has shrunk 7.3 per cent a year since then, damping stock prices despite otherwise impressive earnings growth during the period. Stock investors in the US stayed comparatively bullish.

It is harder to dig up that level of detail for private investments because they operate largely in the shadows, but US private equity and VC could not have asked for a more favourable environment than the one that followed the financial crisis.

Interest rates were near zero for much of the 2010s, allowing private equity to finance acquisitions and VC to bankroll startups at almost no cost. The US also experienced one of the longest periods of economic expansion on record, interrupted only briefly by the Covid-19 pandemic, which stimulated business activity and new ventures, and all of which drove up the valuations of private companies.

None of that was obvious in 2009, however. On the contrary, there was no reason to favour US stocks at the time. The EAFE’s track record stretches back to 1970, and during the subsequent four decades, the performances of developed international stocks and US stocks were almost indistinguishable.

The EAFE returned 10.2 per cent a year from 1970 to 2009, outpacing the S&P 500 by 0.3 percentage point a year. The EAFE also won 56 per cent of the time over rolling 10-year periods.

The underlying fundamentals were also evenly matched. From 1973 to 2009, the earliest year for which EAFE earnings are available, the EAFE and the S&P 500 both saw earnings growth of 5.7 per cent a year. Valuations for the EAFE expanded by 0.9 per cent a year, compared with 0.5 per cent a year for the S&P 500.

And though dividend yields are generally higher outside the US, the difference between the two groups tends to be within a percentage point.

The data for emerging markets is from a shorter period, and therefore it is noisier, but it also would not have pointed to US stocks as the obvious choice. The MSCI Emerging Markets Index returned an eye-popping 13.8 per cent a year from 1988 to 2009. That was 4.3 percentage points a year better than the S&P 500, though US stocks won 73 per cent of the time over rolling 10-year periods.

The earnings of emerging markets grew 3.6 per cent a year from 1988 to 2009, compared with 2.6 per cent a year for the S&P 500. Valuation expansion was almost identical: 1.7 per cent a year for emerging markets and 2 per cent a year for the S&P 500.

And as with developed international stocks, dividend yields in emerging markets are generally higher than in the US, but modestly so.

Looking at the historical record in 2009, it would have been impossible to predict that US stocks would dominate the ensuing 15 years, particularly given how it happened. A handful of US companies that include Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft and Nvidia amassed near monopolistic power that supercharged their earnings growth.

This group, plus Tesla, together known as the Magnificent Seven, accounts for almost all the US earnings growth during the past decade.

The Bloomberg Magnificent 7 Index has posted earnings growth of 36 per cent a year since 2015, the longest period for which data is available, while the earnings of the other roughly 500 companies in Bloomberg’s US large-cap index collectively grew only 6 per cent a year.

These seven companies now account for almost a third of the S&P 500, meaning that for many years the index’s earnings growth and total return have been driven mostly by seven companies. Who could have seen that coming?

The outlook for private investments was also a lot ­different – and perhaps even murkier – in 2009. The US was still crawling out of the financial crisis. Congress and the Federal Reserve marshalled trillions of dollars in fiscal and monetary stimulus to save the financial system.

Many feared that the scale of the response would spark runaway inflation and sharply higher interest rates that would in turn stall the economy and business activity, all of which would have dealt a blow to investors in private companies.

Of course, things turned out very differently. But just as the years before 2010 proved to be a poor predictor of what was to follow, the years since 2010 may turn out to be a poor preview of what lies ahead.

In public markets, betting on the US is effectively a bet on a repeat performance from the Magnificent Seven because, when they are excluded, there is nothing extraordinary about US stocks these past 15 years. And an encore is unlikely.

For one, it is not easy to maintain that degree of growth at their now considerable size. At the end of 2009, the five members of the Magnificent Seven who were then in the S&P 500 were 6 per cent of their current size by market value, 9 per cent by revenue and 7 per cent by net income.

And two, sustaining that degree of relative growth would have absurd results. If the Magnificent Seven were to increase earnings at the same relative pace during the next decade as they did during the previous one, they would eventually make up more than 80 per cent of the S&P 500 by market value. That is not going to happen.

More likely, the Magnificent Seven’s growth will slow, and with it, parity or something close to it will be re-established between the earnings growth of US and overseas companies. Although harder to predict, overseas companies may even outpace those in the US. As for private investments, they face new headwinds.

US interest rates are back near their historical average, which makes leverage more costly for private equity. There are also fewer businesses to buy after private equity’s acquisition spree in recent years, and even fewer at bargain prices. In the startup world, new ventures require less capital than they used to, resulting in fewer investment opportunities and more competition among venture investors.

One sign of the times: BlackRock, the world’s largest money manager, expects Chinese stocks to outperform US private equity over the next 10 years.

None of this means that investors should dump their US assets and plough their money all overseas. But they should think twice about abandoning international markets.

A more reasonable approach is to track the global stock market using low-cost index funds. US companies currently account for about 60 per cent of global stocks by market value, so the market is indeed assigning disproportionate value to US stocks, though perhaps not by as big a margin as their relative performance over the past 15 years might suggest.

Investors can probably pass on private investments without missing much.

Putting aside their opacity and high cost, even under ideal conditions, private investments merely kept up with US stocks during the past 15 years, so there is no reason to expect they will meaningfully outperform. And if parity is re-established between US and overseas stocks, investors will have plenty of opportunities in public markets.

For those who still adhere to conventional wisdom, the historical record makes a compelling case for staying the course. BLOOMBERG

The writer, a Bloomberg Opinion columnist, is the founder of Unison Advisors, an asset management firm. This column does not necessarily reflect the opinion of the Bloomberg editorial board or Bloomberg and its owners.