Pinnacle managed accounts are globally diversified. Most investors readily acknowledge that diversification is a benefit in its own right, since it tends to reduce portfolio volatility and helps investors avoid large investment mistakes. Global diversification offers more of the same: By owning stocks in different countries, you presumably get to invest in equities that have low correlations to the U.S. market, meaning they zig and zag at different times giving you a smoother ride as your portfolio grows in value. (This article discusses stock markets, but the same could be applied to almost any asset class.) Since the U.S. represents about 30% of the world’s stock market capitalization, you also get to invest in great companies that make up the other 70% of the global stock market. You will certainly recognize many of these international giants, including Nestle, HSBC Holdings, BP Plc, Vodaphone, Novartis, Royal Dutch Shell, and Toyota, just to name a few.
International diversification can also benefit your portfolio in terms of currency risk. Given the structural risks in the U.S. banking system, the notion of diversifying dollar risk by owning foreign holdings can be very attractive.
For the most part, our strategy for owning international stocks has been to invest in international mutual funds, and our fund managers have delivered excellent returns for our clients over the years. The following chart shows the 1 year, 2 year, 3 year, and 5 year returns for the First Eagle Overseas Fund (SGOVX), IVA International Fund (IVIOX), and Matthews Growth and Income Fund (MACSX), as well as their respective benchmark indices, the MSCI Europe, Australasia, Far East (EAFE) Index of developed countries, and the MSCI Emerging Market Index (EEM). The funds have done extremely well over the past two years versus their international benchmarks.
Annualized Return Percent
Unfortunately, our international investing story doesn’t end there. While First Eagle and IVA International handily beat their benchmark for developed country funds, and Matthews Growth and Income has performed well versus its benchmark, neither of these indices is in Pinnacle’s benchmark for our comparative performance. Once you compare the funds to Pinnacle’s risk proxy — the S&P 500 Index — the numbers begin to look different.
Annualized Return Percent
|IVIOX||SGOVX||MACSX||S&P 500 Index|
For the past three years the international markets in general have dramatically underperformed the U.S. stock market, and it is only the excellence of our fund managers that has kept the relative returns of this allocation of our portfolio at a reasonable level. For example, the EAFE Index return for the trailing two year period is -0.27% annualized versus 5% for the managed funds and 6% for the S&P 500.
Today many institutional investors question the benefits of international investing, especially when it involves investing in developed international markets. One of the main criticisms is that the world is getting smaller every day, and so there’s no longer much of a diversification benefit from investing in developed overseas markets. To see this, we only have to look at the correlation of the EAFE Index to the S&P 500 Index over the past few years. You can see that the correlations are very high, meaning that there isn’t much zigging and zagging going on, and the trend seems to be heading in the wrong direction. Clearly, if the reason you’re investing globally is to gather the high returns and low correlations of international markets, then the past three years have been disappointing on both counts.
Correlation of EAFE Index to S&P 500 Index
Another good news/bad news situation for our investment team is the nature of the international funds that we currently own. We consider all three fund managers to be eclectic, in that they can and do own assets other than stocks in their funds. Both IVA and First Eagle have recently owned large positions in cash and gold, and Matthews often owns as much as 20% of the fund in convertible bonds. All three fund managers’ deep-value style of investing results in the funds having a low amount of volatility versus the S&P 500 Index. The relative volatility of the fund, or beta, is low enough that we consider all three funds part of the defensive allocation of our equity portfolio. (A beta of 1 means we expect the volatility of the fund to be similar to the benchmark, while a beta of 0.5 means we expect the volatility to be 50% of the benchmark.)
1 Year Beta of International Funds versus the S&P 500 Index
|First Eagle Overseas Fund (SGOVX)||0.55|
|IVA International Fund (IVIOX)||0.52|
|Matthews Growth and Income Fund (MACSX)||0.55|
Eclectic managers with low betas compared to the S&P 500 Index are very useful in bear markets when we’re trying to defend against large market declines and minimize losses in a ‘risk-off’ environment. However, sticking with these managers in a bull market when high-beta strategies are being rewarded is problematic. It is doubly so when we believe that the U.S. is likely to lead international markets in terms of relative performance. In addition, if the U.S. dollar were to rally against the euro (assuming Europe leads a decline), we would have to depend on the fund managers to properly hedge the currency, because a rising dollar would make the decline in the fund’s European holdings even worse. Notably, we have already hedged Pinnacle portfolios with long positions in the U.S. currency, but it does add another risk to our international holdings.
None of this means we intend to abandon our commitment to global investing. However, it is possible that we’ll be trimming our international holdings as a percentage of our total portfolios in the near future, and we may consider rotating from our eclectic international fund managers to more indexed positions with higher betas if equities markets consolidate and correct (as Rick Vollaro recently explained). Should we decide to restructure the international positions in Pinnacle portfolios, the team will be writing a lot more about it in this space.