“U.S. Stocks Close at Records” was the headline of a front-page article in a recent edition of the Wall Street Journal. As a result of strong recent results, the S&P 500 Index, a widely-followed index that tracks the performance of large-cap U.S. stocks was up more than 10% year to date through September 30. Over the last 12 months, the index was up nearly 18%, according to data from Ycharts.
Many investors with of all stripes with varying objectives and risk tolerances may have examined a recent account statement or checked their balance online and noticed that their portfolio hasn’t fared quite so impressively. In this brief commentary, we offer our thoughts as to why this may be the case.
The short answer is that most investors hold balanced, globally diversified portfolios. What this means is that they, by definition, hold assets other than just U.S. large cap stocks. In an environment in which U.S. large-cap stocks have outperformed most all other major asset classes that comprise a typical globally-diversified, balanced investor’s portfolio, every dollar or percentage point of portfolio assets allocated to something other than U.S. large-cap stocks has hampered performance relative to a portfolio entirely comprised of these stocks over the last year. For many investors that we work with, we see three potential primary contributors to a portfolio’s underperformance relative to the S&P 500 over the last year.
Potential contributor #1: Investors typically own some bonds to provide ballast in their portfolio and to dampen the volatility of stocks. While stocks are typically held to play the role of “return generator” in a portfolio, high-quality investment-grade bonds are sought after to play the role of “risk manager.” The appropriate mix of stocks and bonds in a portfolio is investor-specific and is driven by each investor’s unique objectives, spending needs, time horizon and willingness to bear risk. Investors with high spending needs, a short time horizon and who are unable or unwilling to tolerate substantial volatility in their portfolio will generally hold a portfolio more heavily allocated to bonds, while those with the opposite traits will generally hold a higher allocation to stocks. As you can see in Exhibit 1, bonds have significantly trailed stocks year to date and over the last year.
Potential contributor #2: Many investors diversify their stock holdings beyond U.S. borders by holding international stocks. Global diversification across geographies broadens the investment horizon and positions the portfolio to capture returns wherever they may occur. While in hindsight, we are easily able to ex-post or after the fact observe that U.S. stocks outperformed their international peers over the last year, what’s often forgotten or otherwise not appreciated is that we did not (and neither did anyone else) know that would be the case ex-ante, or prior to the fact. This is ultimately the crux of the case for international diversification. Absent possessing a crystal ball that will reveal ex-ante whether U.S. or foreign stocks will outperform, the best we can do is to diversify so as to ensure we capture some of the strong returns wherever they ultimately occur. Over the long-run, diversification works to smooth out the volatility of the ride by making the highs a bit less high and the lows a bit less low. Depending on an investor’s unique situation, we generally recommend investors allocate 30% or more of their stock holdings to international stocks absent any other investor-specific considerations. As you can see in Exhibit 2, foreign developed market and emerging market stocks have significantly trailed the S&P 500 over the last year.
Potential contributor #3: Many investors may “tilt” their portfolio to overweight value stocks relative to broad stock market indexes. A large body of evidence shows that value stocks (i.e., those trading at a low price relative to some fundamental measure such as book value of equity or earnings) have historically outperformed their growth stock counterparts and by extension the broad market averages not just in U.S. markets but in many other markets around the globe. Like all other successful strategies, the value investing approach goes through periods of underperformance where value stocks trail the broader market. While such periods are unfortunate and can be difficult to live through, we view them to be necessary and integral to the potential long-term success of the strategy. Without the uncertainty associated the potential for periodic underperformance we believe we are unlikely to see persistent differences in expected return over the long run. As Exhibit 3 demonstrates, U.S. value stocks have notably trailed the S&P 500 over the last year.
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 “Factor Based Investing: The Long-Term Evidence” by Dimson, Marsh and Staunton; “Investing With Style: The Cash For Style Investing” by Illmanen, Israel and Moskowitz; “Explaining Stock Returns” by Davis; and “A Review of the Empirical Evidence on the Dimensions of Expected Stock Returns” by Dai.
Past performance is no guarantee of future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. All performance referenced is historical and is no guarantee of future results. No strategy assures success or protects against loss. The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All investing involves risk including loss of principal. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks. Value investments can perform differently from the market a whole. They can remain undervalued for long periods of time.
Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Bloomberg Barclays US Aggregate Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency). Bloomberg Barclays Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. MSCI World ex USA Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of 22 of the 23 developed markets included the MSCI World Index (excluding the US). MSCI Emerging Markets Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. Russell 1000 Value Index measures the performance of the broad value segment of U.S. equity value universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.