author: Russ Koesterich

Global diversification should offer better risk-adjusted returns

1Over the past six years investors have been rewarded for adopting a consistent and simple strategy: overweight the US. For most of this period, a straightforward 60/40 blend of US stocks and bonds has outperformed most other asset allocations.

The success of this strategy for so long defies the advice of most financial experts who tout the benefits of diversification. But it is unlikely to work so well in future. Three arguments support the need for more diversification, particularly in equities.

US stocks have become more expensive, especially compared with the rest of the world. Over the past five years, one of the most repeated refrains used to defend a strong US equity overweight was that the US was “the best house on a bad block”. In retrospect, this was completely correct. However, this willingness to pay up for US equities has resulted in several years of steady multiple expansion.

The current premium on US stocks may be justified in the context of low inflation and low interest rates, but valuations look stretched relative to the rest of the world. Currently the priceto- book ratio on the S&P 500 is roughly 75 per cent higher than on the MSCI All Country World Index-ex US. This is the highest premium since the market bottom in 2008.

Longer-term valuation measures, most notably the cyclically adjusted price-to-earnings or Cape ratio, are even more troubling, The US Cape is in the upper quintile of historical observations. Historically, similar levels have been associated with below average returns over the subsequent five years. By comparison, Cape ratios are much lower in other developed markets.

Meanwhile, the US accounts for a shrinking share of global output. Thirty years ago, the US represented roughly a third of global output; today the number is closer to 20 per cent.

While it is true that international sales represent a growing portion of revenue for US companies, even for companies in the S&P 500 foreign revenue still only accounts for 35 per cent of overall sales. Investors who remain concentrated in the US will be lacking exposure to most of the rest of the world.

There is a more basic reason to bring down the significant US overweight evident in many portfolios: diversification still matters. Over the long term, a more geographically diversified portfolio should lead to better risk-adjusted returns.

Given the breadth and diversity of the US economy and market, it is understandable that many investors feel comfortable keeping their money within US borders. But while the tendency is understandable, it is still not optimal. International markets do offer diversification, in the process lowering the volatility of the overall portfolio.

2Still, while few object to diversification in principle, many argue that it does not work when most needed: during a crisis. It is true that during the financial crisis about the only two asset classes that provided any real hedge were haven bonds, including Treasuries, and gold.

Even in the years immediately following the crisis, correlations remained unusually high as investors fixated on events that transcended asset class and geography — the European debt crisis, US fiscal cliff, Greece. However, a crisis is the exception that proves the rule.

In fact, correlations historically have risen during crises, when investors, who normally have different time horizons and strategies, all become more fixed on the near term. As everyone focuses on a single event or issue, it should come as no surprise that risky assets all behave in a similar fashion. Fortunately, these periods do not last.

Over the past three years correlations have been dropping. Today, inter-country correlations stand at 0.53, a level consistent with the pre-crisis average. This means the benefits to international diversification should be greater than they have been during most of the post-crisis environment.

A still strong domestic economy, low oil prices and a benevolent Federal Reserve all suggest the bull market in US equities can celebrate its seventh anniversary.

That said, future gains are likely to be more muted and accompanied by more volatility, particularly if the Fed does start the long-overdue process of normalising monetary policy. While still likely to contribute, US equities should occupy a smaller share of investor portfolios.

Russ Koesterich is global chief investment strategist at BlackRock.