Over the past six years, international stocks — those of companies from both developed countries and emerging markets — have outperformed U.S. stocks by a wide margin. Many investors, including those saving for retirement and those in retirement, have been attracted by the potential for enhanced returns.
So far this year, however, U.S. stocks, as measured by the Standard & Poor's 500 stock index, have outperformed those from other developed countries and emerging markets. Does international investing still make sense for the average retirement-oriented investor?
I think it does. Recent performance should not determine future allocations. At the same time, while the majority of stock capitalization is now outside the United States, that alone is not a reason to allocate more than half of one's portfolio to foreign stocks.
Instead, investors should base their equity allocation decisions on a market's long-term growth prospects and its "price tag," or valuation. By those measures, even taking into account recent performance, the markets that fare best reside mostly outside the United States.
One stumbling block to international investing is that many investors still perceive companies and products as being either American or foreign. The truth is somewhere in between.
The iPod, for instance, Cupertino, Calif.-based Apple Inc.'s ubiquitous music player, has more than 400 parts, which are produced in multiple factories in at least four different countries. The 787 Dreamliner, an upcoming aircraft from The Boeing Co. of Chicago, while assembled in Everett, Wash., has wings that are made in Japan, flaps in Australia and doors in Sweden. As consumers, we don't have a problem buying goods that are truly global, but as investors, our thinking might still be influenced by decades of inertia, coupled with a phenomenon usually referred to as "home bias."
Studies point to a curious phenomenon: When determining asset allocation, investors in developed countries tend to favor their domestic market. Swedish investors, for instance, tend to allocate most of their stock exposure to local stocks, even though the Swedish equity market represents only a minimal part of world stock market capitalization. Among the reasons cited for home bias are a lack of familiarity with foreign stocks and companies, regulatory barriers, and high transaction and management costs.
In the United States, sentiment toward international investing has changed over the past few years. Buoyed by a sluggish domestic market, booming returns abroad and a weak dollar, institutional and retail investors have rushed overseas, often without regard for timing or price. Today, there is so much choice among international mutual funds, ETFs and other vehicles that asset allocation can be haphazard and perhaps too easily swayed by someone's "hot" idea, without regard for market fundamentals.
With that in mind, and based on measures of valuation and growth, what kind of international retirement asset allocation makes the most sense?
In terms of valuation, the "cheapest" markets appear to be emerging markets (priced at 8.2 times earnings) and developed Europe (at 8.9 times earnings). These are followed by Latin America at 9.8 and Asia at 11.6. The United States trades at roughly 12.5 times earnings, with only Japan ahead at 15.8. Similarly, emerging regions of the world rank highest in expected earnings growth, trailed by the developed markets of Europe and the United States.
Taking into account other factors, such as broad economic fundamentals and central-bank policies, a core/satellite approach to international investing seems to make sense.
For the core, advisers could allocate their client's retirement assets using a global equity strategy, allowing a manager to go anywhere in the world, developed or developing, in search of alpha.
To boost those returns, the satellite portion could feature a variety of strategies, including regional emerging markets, alternatives and commodities, and perhaps even U.S. mid-cap value or small-cap growth.
The main concern of an investor heading into retirement should be to identify and allocate assets to markets that are growing faster than their peers. If this is done with proper timing and at a reasonable price, the chances of outperforming a U.S.-centric allocation increase significantly.
Vladimir Milev is an investment analyst who focuses on Eastern Europe's equity markets at Metzler/Payden LLC in Los Angeles.
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