The common belief that international equities can

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1 August 2005 International Equities Are Investors Missing the Opportunity? Robert E. Ginis, CFA Senior Investment Strategist Global Quantitative Management Group Steven A. Schoenfeld Chief Investment Strategist Global Quantitative Management Group profit from long-term structural changes in cross-border production and consumption patterns. The common belief that international equities can improve a U.S. portfolio s risk/return profile has lost support from many investors in recent years. Some market watchers point to greater correlations between non-u.s. and U.S. markets as evidence that the diversification benefits from investing abroad have eroded and do not warrant the perceived additional risks associated with international investing. Despite the theoretical and practical underpinning for overseas diversification, U.S. investors systematically underweight international stocks. By underweighting international equities, investors risk not participating in the higher expected future economic growth outside of the U.S. Those investors who do take the international plunge often make two mistakes, in our view, that limit their ability to profit from non-u.s. investing, thus reinforcing the belief that investing outside the U.S. is no longer attractive. These mistakes include underweighting their allocation and failing to adequately define the international equity asset class. This persistent home-country bias truncates the opportunity set for most investors and limits their ability to Within the Global Quantitative Management Group, we believe there are several compelling reasons to include or even increase international equity allocations today. Furthermore, we consider a highly effective method for obtaining core non-u.s. exposure to be indexbased strategies both passive and enhanced-indexing. Putting such a program into action involves understanding the appropriate definition of beta for non-u.s. allocations and applying a similar risk-budgeting framework that supports U.S. core allocations. International Equity Allocations Lag Growth Opportunities While the long-term performance comparison between the U.S. equity market (as measured by the S&P 500) and international equities (as measured by MSCI EAFE) marginally favors the U.S., the advantage is tipped by the relatively brief period in the late 90s when the technologytelecoms mania prevailed. As shown in Figure 1, from December 31, 1969 through January 1995, international equities outperformed U.S. equities by almost 40 cumulatively. From January 1995 through August 2000 (the peak in the S&P 500), the markets reversed, with

2 Figure 1. Long-term Equity Market Performance Growth of $1 invested on December 31, 1969 $100 S&P 500 MSCI EAFE $42.29 $31.56 $10 Tech Bubble Drives S&P 500 $1 $0.1 Dec 69 Dec 72 Dec 75 Dec 78 Dec 81 Dec 84 Dec 87 Dec 90 Dec 93 Dec 96 Dec 99 Dec 02 Dec 04 Sources: Northern Trust Global Investments, Standard & Poor s, Morgan Stanley Capital International, Inc. international equities underperforming by 18. Since that time, international equities have once again outpaced domestic equities, posting 16% higher returns for the period since the peak of the bubble through the end of To meaningfully participate in growth beyond our borders means investors simply cannot afford to limit their investment universe by corporate domicile and overlook the 95% of the world s population and 8 of world GDP that exists outside of the U.S. (See Figure 2). In fact, it is the rise of the middle class in many of the larger emerging markets such as India, Brazil, China and Russia that is fueling a boom in domestic demand not simply Figure 2. World Growth and Population World GDP US 21% Developed Markets ex-us 34% Population US 5% Developed Markets ex-us 11% Emerging Markets 45% Emerging Markets 84% Sources: Northern Trust Global Investments, World Bank, World Development Indicators database, April 2005 export-led growth as has historically been the case. Furthermore, a number of world class companies such as Samsung in Korea, Embraer in Brazil, Cemex in Mexico, InfoSys in India and dozens of others are domiciled in emerging markets yet are major global players in their industries. Reduced tariffs, improved terms of trade, transparency and government deregulation have fostered significant productivity gains and economic growth in a low interest rate/low inflation environment. This has lead to a climate of strength in non-u.s. companies, markets and currencies as well as forecasts of a continuation of the erosion of U.S. dominance in many industries. Concerns that diversification benefits are being eroded away and that volatility is now permanently higher have proved incorrect as correlations have flattened and volatility increases have reversed. Similarly, investors are often concerned about the implicit risk of currency fluctuations that come along with exposure to foreign securities. The fact is that part of the benefit of investing internationally is obtaining diversified currency exposure, as this is a significant component of the overall return of international investment (See Figure 3). Approximately 2% of the total annualized performance of MSCI EAFE, or half of the cumulative return since 1969, can be attributed to currency movement (and it should be noted that investors who hedged part or all of their international equity exposure gave up much of this return). 2

3 Figure 3. Currency Performance in MSCI EAFE 8 6 Annual Total Return of EAFE, in U.S. Dollars Currency Contribution to Return Sources: Northern Trust Global Investments, Standard & Poor s, Morgan Stanley Capital International, Inc. Investors Continue to Underweight International Equities While investors have begun to recognize the benefits of investing outside the U.S. and, therefore, allocations to international equities have been rising, they are still not commensurate with the global opportunity set, as over half of listed equities are found outside the U.S. Recent analysis by InterSec (Figure 4) shows an increase in cross-border holdings by U.S. plan sponsors from less than $2 billion in 1979 to over $1 trillion in 2004, a staggering 59,00 increase. Despite this growth, institutional investors still hold only 16% of their portfolios in non-u.s. equities. Perhaps not too surprisingly, this mismatch between actual holdings of domestic equities and their benchmark representation is a phenomenon that is prevalent and even more pronounced in overseas markets, as noted in a recent International Monetary Fund (IMF) report (Figure 5). Figure 5. Actual and Benchmark Holdings Comparison (12/31/04) Actual holdings of domestic equities Benchmark holdings of domestic equities US Japan UK Canada Germany Sources: Northern Trust Global Investments, International Monetary Fund Efficient markets theory suggests that, absent impediments to free flow of capital, rational investors seeking to build a market portfolio would construct them with an eye on the actual distribution of available equities. Figure 4. Total Tax-Exempt Cross-Border Assets (externally managed) $1,600 18% $1,400 $1,200 $1,000 $800 $600 $400 $200 $1 16% 14% 12% 1 8% 6% 4% 2% Total Assets Invested Outside U.S. ($ billion) E2009 Assets (left) Allocation (right) Equity Allocation Outside U.S. Sources: Northern Trust Global Investments, InterSec 3

4 Adding Alpha by Redefining Beta Beyond the diversification and potential outperformance benefits discussed above, investors have the potential to gain alpha for their portfolios via a broader and deeper definition of the beta associated with non-u.s. stocks. The standard non-u.s. market universe that investors typically use represents only 2/3 of the total international equity opportunity set. Because of this benchmark gap, institutional investors tend to systematically underweight or overlook Canada, developed international small cap and emerging markets, which collectively account for $4.1 trillion of non-u.s. equities $12.6 trillion of investable capitalization (Figure 6). Figure 6. Non-U.S. Market Capitalization by Region (12/31/04) Developed Non- North America 67% Other 33% Sources: Northern Trust Global Investments, Standard & Poor s, Morgan Stanley Capital International, Inc. Canada 5% Developed International Small Cap Emerging Markets 8% Yet, as can be seen in Figure 7 below, all three of these market segments have had periods of dramatic outperformance relative to EAFE and its equivalents. By ignoring or underweighting Canada, international small cap and emerging markets, investors are leaving potential alpha on the table, and should consider shifting to more complete total international equity policy benchmarks concurrent with an increased overall allocation to international equities. There are also correlation benefits to expanding the benchmark beyond EAFE. While correlations between the EAFE index and the S&P 500 have been rising, the other components of the international equity asset class demonstrate the value of maintaining broader exposure (See Table 1). Moreover, correlations for international equities fluctuate widely over time. Table 1. Correlations with S&P 500 ( ) Developed International Small Cap 0.53 Emerging Markets 0.63 EAFE 0.65 Canada 0.75 Sources: Northern Trust Global Investments, Standard & Poor s, Morgan Stanley Capital International, Inc. The Arithmetic of Active Management Also Prevails in International Equities U.S. pension plan sponsors have become steadily more sophisticated in their choice of benchmarks and allocations for domestic equities during the past 10 years. The application of risk budgeting in this framework has resulted in extensive use of indexbased strategies at the core of domestic allocations, and it is reasonably well-accepted that indexing has an important role for efficient markets such as large-cap U.S. equities. In fact, most sophisticated investors now combine index, enhanced index and traditional active management to build domestic portfolios to more efficiently achieve targeted levels of risk and return. Figure 7. Differential Market Performance 8 6 Annual Return in U.S. Dollars 4 4 EAFE Canada Developed International Small Cap Emerging Markets Sources : Northern Trust Global Investments, Standard & Poor s, Morgan Stanley Capital International, Inc. 4

5 However, this logic is much less frequently applied to international equities. This is because the median active manager outperformed EAFE from the mid-1990s through 2001, according to InterSec universe data. But a lot was changing under the surface for both international benchmarks and investment managers, and by 2000 and 2001, three important transformations in the framework for international equity investing were underway which were diminishing the opportunities for active managers to outperform. Evolution of EAFE, as well as the FTSE, Dow Jones and S&P equivalents to float adjustment, resulting in a deeper and more complete benchmark, better reflecting the true opportunity set available to active managers. More precise use of benchmarks we call these integrated international strategies by investors and their consultants. Active managers whose mandates allowed them to invest, or dabble, in emerging markets were increasingly measured against benchmarks that included these developing countries. Costs and research intensity was converging to U.S. levels, especially in Europe with increasing integration and adoption of the Euro. The relative performance of active international managers since the early 2000s has begun to look more like that of domestic active managers (Figure 8.) And, like their U.S. counterparts, the median manager in most non-u.s. universes is increasingly struggling to outperform. One should also note that the erosion of outperformance began in the timeframe, and continues to this day. In fact, on a calendar year basis, for both 2003 and 2004, EAFE outperformed the median manager. In 2003, 61% of managers failed to beat the index, while 58% failed to beat the index in Therefore it is likely that the rolling three year figures that are used by consultants and plan sponsors will reflect this and show the median active manager underperforming the main international equity benchmarks. It is the view of the Global Quantitative Management Group that the longer this underperformance of traditional active management persists, the more likely it is that institutional investors will begin shifting their core international equity holdings to index-based strategies. What s more, even as those managers are struggling to meet their performance objectives, the increasing allocations to international equities is creating capacity constraints, making it difficult for asset owners to get the asset class exposure they are seeking. Even in emerging markets, where some feel that traditional active management is not only sensible, but a necessity, indexing can play a leading role. The higher transaction costs and lack of transparency in these markets present a significant hurdle to realizing excess returns, particularly for active managers, who in their pursuit of alpha, have much higher turnover and therefore a higher deadweight cost to overcome. While this is not an indictment of traditional active management for international equities, it should serve to remind investors that they must have deep confidence in their chosen manager s ability to deliver outperformance in the future. Thus, the logic and arithmetic of using index-based strategies, whether passive or enhanced index, at the core of an international equity commitment is growing more compelling as non-u.s. markets mature. We believe that investors who adopt this approach will benefit in the same ways, with more efficient and consistent exposure to the dynamic companies and economies beyond American shores. Figure 8: Active EAFE Manager Performance 1 Excess Returns (Rolling Three Years) First Quartile Median 8% 6% 4% 2% -2% -4% Dec 92 Dec 93 Dec 94 Dec 95 Dec 96 Dec 97 Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Sources: Northern Trust Global Investments, InterSec 5

6 This report is for informational purposes only. Past performance is no guarantee of future results. The views expressed herein do not constitute investment advice or a recommendation to buy or sell any security or investment product. Since the date of this publication, economic and market conditions and the authors views of the prospects of any particular investment may have changed. The returns shown are those of various market indices and do not reflect the deduction of investment advisory fees. It is not possible to invest directly in an index. The information contained in this publication has been obtained from sources believed to be reliable, but the accuracy, completeness, and interpretation cannot be guaranteed. The S&P 500 Index is a registered trademark of Standard & Poor s, a division of the McGraw-Hill Companies, Inc. The MSCI EAFE Index is the Morgan Stanley Capital International Europe, Australasia, and Far East Index, an unmanaged index that tracks the performance of selected equity securities in Europe, Australasia and the Far East. Northern Trust Global Investments comprises Northern Trust Investments, Inc., Northern Trust Global Investments (Europe), Ltd., Northern Trust Global Investments Japan, K.K., the investment advisor division of The Northern Trust Company and Northern Trust Global Advisors, Inc. and its subsidiaries to offer investment products and services to personal and institutional markets. Northern Trust Global Investments The Northern Trust Company 50 South LaSalle Street Chicago, Illinois Q11401 (8/05)