The case for active international equity funds in participant portfolios.
After decades of strong economic growth and a six-year-long stock market rally, U.S. equities still account for 45% of global market capitalization. American investors with only domestic equity exposure miss more than half of the world’s growth potential from international equity markets.
It’s no secret that adding international funds to DC plans can help participants take advantage of the wide range of investments now available outside the U.S. In addition, by including international equity in their long-term retirement plan portfolios, participants with suitable risk tolerance can potentially smooth volatility and add incremental returns, as history shows that certain markets can generate stronger returns when other markets struggle.1
Most plan sponsors, through their advisors and investment committees, have recognized the importance of international equities and added them to their DC plan’s investment lineup. In fact, nearly 98% of all 401 (k) plans offered an international equity component in 2014.
Although plan sponsors agree on the importance of including international equities in the investment lineup, plan participants have been more reluctant to include them in their own retirement portfolios. A BrightScope/ICI report found that when making equity investing choices, plan participants overwhelmingly preferred domestic (31%) over international (8%) funds.
Percentage of DC Assets Allocated to Equities (left)2 & Equity Funds Asset Percentages in DC Plans (Right) 3
Trend 1: Reliance on recent U.S. equities performance
While U.S. equities have delivered solid returns for the past five years, investors should not expect that trend to continue indefinitely. In fact, recent dips in U.S. equities markets this year — after a historic run since March 2009 — support the argument that participants should increase their international equity allocations for increased diversification. Says William Adams, portfolio strategist at The Boston Company, a BNY Mellon affiliate, “U.S. investors have had a pretty nice tailwind from overexposure to our domestic market relative to Europe, Japan and even emerging markets over the past five years. But that’s not always been the case, nor should you expect it to be so in the future. Investors should consider the widest possible opportunity set.”
However, to a casual observer, the investment landscape beyond the U.S. today looks less than promising: Europe’s ongoing debt problems, Japan’s fitful attempts to overcome decades of stagnation, China’s struggle to restructure its economy and recent currency devaluation, and prospects for further turmoil in emerging markets may suggest to participants that the best investment choices remain U.S.-based.
Trend 2: A preference to stay close to home
Choosing familiar domestic equities over less-well understood international alternatives may also stem from what behavioral finance experts call a “home bias”— that is, the preference by investors to own the stocks of companies domiciled in the countries where they live. Home bias though, can lead to a high domestic equity allocation, introducing the risk of having too many highly correlated assets moving in sync when the market declines. Besides raising a portfolio’s volatility risk, an over-allocation to domestic equities can also mean missing other opportunities to seek alpha, or incremental returns. As mentioned, domestic equity exposure only in a portfolio causes investors to miss more than half of the world’s growth potential available from international equity markets. U.S. participants may choose what is familiar to them, yet in doing so, miss out on diversification opportunities over time.
Trend 3: Less knowledge about international equities as an asset class
Since the signing of the Bretton Woods agreement in 1944 that established the International Monetary Fund and laid the groundwork for international financial integration, individual and institutional investors have slowly but steadily shifted their focus from the opportunities and risks present in their home countries to those existing across borders and overseas. The collapse of cold war geopolitical barriers to economic integration and improvements in information technology over the past two decades accelerated this trend and gave investors even wider opportunity sets to pursue.
But, even as the globalization of financial markets has made more investment opportunities available, individual investors and plan participants in the U.S. have been slower than those in countries such as Canada and the U.K. to add international allocations to their portfolios — and to think about international equities as a separate asset class from domestic equities. In addition to their home country bias, this reluctance to “go global” may reflect participants’ long-held view of the U.S. as the world’s sole economic superpower, rather than the present-day reality of more widely distributed global economic growth.
Helping participants understand the role that international investments can play in further diversifying their portfolios and delivering incremental risk-adjusted returns can help improve their comfort level with international equities. As the chart below shows, adding an international equity component can reduce risk (as measured by standard deviation), without diminishing returns.
Amid opportunity, key risks to be managed
While opportunities are abundant in international equities, the perhaps unfamiliar risks posed by currency fluctuations, political and economic turmoil and a lack of transparency are unique to global investing and worthy of attention. Active managers with international risk experience, knowledge and nimbleness can potentially reduce the impact or enhance the advantage.
Carl Mastroianni, currency specialist with Insight Investment, a BNY Mellon affiliate, points out that many U.S. investors who have added exposure to global equities have done so during a period of relatively low currency volatility. “Since the financial crisis, the dollar has been weak for the most part,” he says. “Global central banks, including the Federal Reserve, have kept interest rates low, and the dollar has remained weak. Most international investors have benefited when their gains from investments denominated in strong currencies have been translated into weak dollars, but now they risk currency translation losses when the dollar is strong,” says Mastroianni. “Many investors have not been cognizant of this ‘hidden’ risk in their portfolios because it has not really hurt them. Our belief is that they should at least recognize these risks and make some strategic decisions around them.”
William Adams of The Boston Company also recognizes the importance of currency policy when considering increasing a global asset allocation but notes that patient investors can look past recent shifts in relative currency values, particularly as they look out over the next one to two years and see that the earnings cycle for Europe and Japan has become much more favorable than for the U.S.
Country selection by investment managers is also an important aspect of managing risk in international investing, especially when investing beyond developed markets. Attractive relative value opportunities exist in politically risky countries as well as in stable, well-governed countries with solid growth forecasts. Strategist Scott Helfstein of BNY Mellon Investment Management's Center for Global Markets notes that while opportunity can be found in politically delicate situations, investment risk must always be managed carefully.
Active investment managers can employ fundamental research to identify opportunities, particularly in fast growing emerging and frontier markets that other investment managers have not yet uncovered. Global investors should keep in mind the differences between emerging market economic juggernauts such as India that offer improving governance, attractive equity valuations and much higher projected growth than the U.S., and riskier markets such as Brazil where scandals and falling commodity prices have created the potential for political instability.
There are also some interesting things happening on the ground in Japan and Europe related to restructuring opportunities. “In the U.S., we’re very accustomed to seeing a lot of quick government policy response to market turmoil, and also corporate responses in the way of restructuring,” says Adams. “In corporate Japan and Europe, that’s only now beginning to happen and that may create additional opportunity for global equity investors. Now, non-U.S. companies are starting to take a harder look at profitability, return on equity and shareholder value, things that we as U.S.-based investors take more for granted in our corporate culture.” This ongoing evolution and expansion of the opportunity set in global markets showcases the potential for active managers to generate alpha.
What plan sponsors should do now
With such risks in mind, plan sponsors and their investment committees should exercise an extra measure of due diligence when reviewing their current international investment lineup and evaluating international managers and strategies for their potential to deliver consistent riskadjusted returns to participants. They should educate them on properly including international funds in diversified portfolios, and provide clear guidance on selecting international equity investments.
To achieve both objectives, plan sponsors should consider these three steps:
Step 1: Ensure that their plan’s investment policy statement (IPS) outlines the approach to and philosophy about the types of international equity offerings the plan makes available to its participants. In this effort, it’s also important for plan sponsors to consider the merits of active, as well as passive, international equity options.
Step 2: Confirm that the international equity options provided are suitable for the investment experience of the participants based on their needs and behaviors. This requires that plan sponsors and their investment advisors and committees:
- Select international equity funds that actively manage risks with an eye toward reducing volatility. This allows participants to be more comfortable allocating a portion of their portfolio to international equity.
- Look at relative “risk-adjusted” performance rather than just annual returns in the selection process. Measures of risk-adjusted return include Sharpe ratios, information ratios, Treynor ratios and Jensen’s alpha. Plan advisors can help sponsors evaluate their current international equity funds through that lens.
Step 3: As part of the plan’s education efforts, provide participants with information and guidance on the benefits of investing beyond U.S. borders.