The practice of allocating investment dollars among different “asset classes” (e.g., small cap, large cap, international, etc.) is commonplace among financial advisors.  Asset allocation has well-established academic roots, though academics tend to define risk exclusively as security price volatility.  We’ve written numerous other times about how volatility is, at best, an incomplete way to construe risk.  If we were to use this myopic definition of risk, and if we thought that reducing volatility was the end-game (which we don’t), we might concede that allocating investment dollars among several asset classes “works.”

The stock / bond allocation mix has the biggest impact on volatility by far and, as such, we think it is a very important type of asset allocation.  Including other asset classes may also reduce volatility and increase return, but once the basic stock / bond mix is determined, there aren’t a lot of additional asset classes that offer a significant return or volatility impact.  More pointedly, we’re very skeptical about whether utilizing several different international mutual funds accomplishes either volatility reduction or return enhancement in investment portfolios.

We made a simple study of the S&P 500, “SPY,” and the Vanguard Total World Stock, “VT,” ETFs to try understand whether our skepticism is warranted.  According to the Vanguard site, VT is allocated: North America: 53%; Europe: 24%; Pacific: 14%; and Emerging Markets: 9%.  While allocations from advisor to advisor will certainly differ from this, we believe it is a reasonable proxy for illustrative purposes.  SPY, on the other hand, represents only U.S. domiciled large companies.  Our date range was, admittedly, fairly short: 12/31/2008 through 12/31/2013.  We were limited by the fact that VT’s inception is only slightly older than our start date (6/24/2008).  Furthermore, though the period was only 5 years, we also note that this particular 60 month period does include three different phases of the global economic cycle, from contraction to recovery to expansion.

We looked first at one year price returns and noted that VT had out-performed the SPY in 2 of the 5 years studied (2009 and 2012):

Adjusted 1 Year Price Performance for the Periods Ending

12/31/2009

12/31/2010

12/30/2011

12/31/2012

12/31/2013

SPY

26.4%

15.1%

1.9%

16.0%

32.3%

VT

32.7%

13.1%

-7.5%

17.1%

22.9%

However, when we looked at periods covering multiple years, we found that VT consistently underperformed the S&P 500:

Annualized Price Performance for the Periods Ending

5 Yr CAGR*

3 Yr CAGR

3 Yr CAGR

3 Yr CAGR

12/31/2013

12/31/2013

12/31/2012

12/31/2011

SPY

17.9%

16.1%

10.8%

14.0%

VT

14.8%

10.0%

7.0%

11.5%

*Compound Annual Growth Rate

 

On this limited basis, a naïve allocation to only U.S. multi-nationals was more successful than a more fully globalized allocation.  Then we asked, “But what about the purported volatility-reducing benefit of global asset allocation?”  Looking at the returns over the same five year time frame, we unexpectedly found out that volatility was actually higher with the global asset allocation portfolio than the S&P 500:

Standard Deviation* for the Years Ending

5 Yr Standard Deviation

3 Yr Standard Deviation

3 Yr Standard Deviation

3 Yr Standard Deviation

12/31/2013

12/31/2013

12/31/2012

12/31/2011

SPY

11.7%

15.2%

7.9%

12.2%

VT

14.9%

16.2%

13.2%

20.1%

*Standard deviation is a statistical measure which describes historical variance around a mean.  Among financial advisors, it is commonly used to describe portfolio risk.

 

Taken together, what do these data points tell us?  First, investing globally may or may not mean higher returns than investing in U.S. large companies over any given year.  And, at a minimum, large U.S. companies should not automatically be expected to underperform a global allocation over multi-year holding periods.  Secondly, global asset allocation practices may not actually reduce volatility.  We discuss possible reasons for this phenomenon in our whitepaper, “Global Investing: Expanding Opportunities in an Integrated World.”

Our skepticism about financial advisors’ practice of global stock allocation remains.  Often times, it appears to us that financial advisors recommending multiple international funds to their clients are really just hoping to have something positive to discuss in years when U.S. multinationals haven’t performed very well.  As we invest, we utilize companies from around the globe, not just U.S. multinationals.  But we invest in those companies in part based on their ability to give us access to growing international markets.  We never invest based on an address.