Investment Insights

Investment Insights: Why International Securities?

17 December 2019

By: J. Reed Murphy, CIO

Contributions by: Rob Young, CFA 

Bias. As the famous author, Malcolm Gladwell, has so eloquently illustrated in many of his writings, perhaps none so profoundly as Blink: The Power of Thinking Without Thinking, humans are prone to biases. Gladwell has an insightful way of illustrating how the mind works psychologically in cultural, social and economic settings. His insights are a practical and broader application of what several Nobel Laureates have illustrated in behavioral economics and finance. People have biases and it impacts our decisions.

This paper highlights one of the more popular biases in behavioral economics – Familiarity Bias. The avoidance of investments that we either don’t understand or are less familiar with is a classic form of familiarity or home bias. It exists within all humans and in all countries.

We’d like to dispel this thought process and highlight that, for a number of reasons, most investors should carry a core position in international securities. In this paper, we will answer the following key questions:

How Does the U.S. Equity Market Compare to the Rest of the World?

There are several factors to consider before making a decision to include or avoid international equities. To begin, focusing on demographics and certain fundamentals provides a broader context for decision making. Consider the following. The U.S. represents:

4% of world’s population,
10% of the world’s publicly traded companies,
24% of world’s economy and
56% of its total stock market (market cap basis).

However, as shown in Exhibit 1 U.S. investors allocate a disproportionate 74% of their overall equity allocation to the U.S. By avoiding international investment opportunities categorically, investors could be dramatically reducing their opportunity set for successful investing.

Why is Comparing a Group of U.S. Stocks to a Group of “All Other” International Stocks Misleading?

The most common pitfall investors make is comparing the U.S. equity market as a group to all other international stocks as their own group. In making this binary comparison, one is generally comparing the S&P 500 (index comprised of 500 companies) to the Morgan Stanley Capital International (MSCI) EAFE index, comprised of 900 developed market companies or the MSCI Emerging Markets (EM) index, comprised of over 1,100 companies. This comparison is fraught with shortcomings, some of which we will explore. Let’s start by dissecting these shortcomings from a top-down perspective, starting with countries, sectors and individual companies.

REASON 1: Country Performance Gets Lost In Index Performance

The MSCI EAFE (developed countries) index consists of 21 countries and the MSCI EM (emerging markets) Index consists of 26 countries. Each index has unique performance and volatility drivers. As we previously noted, the S&P 500 is representing just one country. In Exhibit 2, we use the S&P 500 as a proxy for United States security performance and compare it to other countries within the MSCI EAFE and EM indexes--in general, since 1990, the U.S. tends to fall near the middle of international country performance. Said another way, an investor that solely uses domestic securities for their equity allocation, misses several international country standouts on an annual basis.

REASON 2: Sector Weighting Differences Are Significant

When comparing the sector weightings of the U.S. in a global stock market context, the S&P 500 has greater exposure to Information Technology, Healthcare and Communication Services, which over the last decade has seen the strongest performance. International indices tend to be heavier weighted to the material, financial and energy sectors, which have seen poorer relative performance (Exhibit 3) in recent years. Making a decision to invest without this perspective leads to less informed decisions.

As we also evaluate the actual performance of economic sectors within a global context, we note that the actual performance differences can be significant. Over the last 20 years (ending November 2019), the average annual sector performance dispersion was meaningful. The Consumer Staples and Materials sectors were fairly tight, but the performance difference within Energy, Financials and Technology was significant (Exhibit 4).

REASON 3: Some of the Best Performing Companies are Not in the U.S.

To further drive the point, according to The World Bank, as of 2018 only 10% of globally available public companies are based in the U.S. Not opening one’s tool box to international companies significantly restricts one’s exposure to some of the best companies and business models in the world. For example (Exhibit 5), Royal Dutch Shell, based in the Netherlands, is the 3rd largest company in the world based on 2018 revenues. Volkswagen, the largest global auto company, is nearly 2x the size of General Motors. Alibaba, a technology and commerce giant, is a Chinese company. Over the last three years Alibaba has grown its revenue at a 55% CAGR versus a ~30% CAGR for Amazon. Nestle is a Swiss company that is nearly 10x the size of Hershey. According to Bloomberg, Novartis represents an uncorrelated option for pharmaceutical investors and while BNP isn’t as large as J.P. Morgan by market cap, its dividend yield is nearly twice as large.  

From a stock performance perspective, the top 50 performing companies on an annual basis have generally been foreign companies. On average only 25% of the top 50 stocks annually since 2009 were U.S. based (Exhibit 6). As a result, if an investor was U.S. based only, they missed some of the best companies and investment opportunities in the world.

How Should One Approach International Investing?

Investing should not be commoditized down to a game of winning or losing. That begs the question – winning or losing relative to what? The decision to include non-U.S. companies should be based on fundamentals and one’s goals.

Goals-based Investing Supports More Tools in the Toolbox

Investing should be client-centered. That is, investing should be goals-based. Considering international equities as part of one’s allocations simply brings more tools into the tool box to help one achieve a desired behavior and outcome. After all, one would not expect a carpenter to only use a hammer and nails to build a home. As we have demonstrated, considering international investments theoretically adds 90% of global companies back into the toolbox.

Active or Passive Considerations

While investible indexes are not available for all asset classes, they do exist for broad international markets. Actual investments in international companies can be obtained through passive (i.e., index) approaches or through active management (i.e., picking specific companies). International markets are certainly less efficient than the domestic large cap market, which further reinforces the point that deciding to invest in U.S. vs. non-U.S. markets should not be based on a binary comparison of stock indices.

Moreover, when indexing, you are set to achieve the same returns (ex-fees), same level of volatility and the same yield as a given index. Not all investors want or need these same behaviors. For those that desire a higher level of yield, investing in international markets (even through an index) can provide higher dividend yield levels than in the U.S. (S&P 500 index). Furthermore, as exhibit 7 illustrates there are far more foreign companies that have dividend yields greater than 3%. As of November 30th, 2019, there were 1,022 companies with dividend yields of 3% or more – 87% of those came from foreign companies. In a low interest rate environment, this is an important additional perspective.

Conclusion

While there are several other factors to consider when investing in international equity markets, the bigger picture suggests there are more opportunities outside of the United States. Considering the allocation to international markets is not only a client-centric decision, but it should also be based on economic and market outlooks.

Being that the international universe is so large, comparing the U.S. to one index representing the entire international market is misleading. Some of the best international managers are picking from among the best countries, sectors and individual companies – all of which is lost when making a binary comparison of the S&P 500 to an international index.

Capital market assumptions may be revised periodically, which can severely alter the results of different analyses. Calamos Wealth Management cannot give any assurances that these assumptions or any results relying upon these assumptions will prove correct. This information is not intended as a recommendation to invest in any particular asset class or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client
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Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. The opinions and views of third parties do not represent the opinions or views of Calamos Wealth Management LLC. Opinions referenced are as of the date of publication and are subject to change due to changes in the market, economic conditions or changes in the legal and/or regulatory environment and may not necessarily come to pass. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
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DEFINITIONS
MSCI EAFE: Index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
MSCI EM: Captures large and mid cap representation across 26 Emerging Markets (EM) countries*. With 1,202 constituents, the index covers approximately 85% of
the free float-adjusted market capitalization in each country. Emerging Market Equity consists of stocks issued by companies of non-US countries classified as either ‘emerging market’ or ‘frontier markets’ within the MSCI World Index or the MSCI Frontier Markets Index. In addition to the general risk of foreign investing, the securities markets of Emerging Markets are substantially smaller, less developed, less liquid, and more volatile than the securities of US and other more developed countries.
S&P 500: Widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
MSCI ACWI is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by the Morgan Stanley Capital International (MSCI) and is comprised of stocks from 23 developed countries and 24 emerging markets
An emerging market economy is the economy of a developing nation that is becoming more engaged with global markets as it grows.
MSCI Inc is an investment research firm that provides indices, portfolio risk and performance analytics, and governance tools to institutional investors and hedge funds.
Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan.