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Why U.S. stocks don’t belong in a global portfolio—now, say strategists

Nov 9, 2017

U.S. equities have enjoyed such a record-setting climb within the past year that long-term expected returns look dismal compared with other assets around the globe, causing analysts at Research Affiliates to advise against including any U.S. equities in an investment portfolio at all—at least now.
That might seem like an extreme tacked.
After all, stock-market bears have persistently declared equities overvalued, notably over the past two or three years, only to witness an unrelenting rally for the Dow Jones Industrial Average DJIA, +0.04% the S&P 500 SPX, -0.02%  and the Nasdaq Composite Index COMP, -0.27%  that has seen all three up at least 16% so far in the 2017. That means, avoiding U.S. stocks this year might have cost investors sizable potential gains.
Moreover, the S&P 500 nominal annualized three-year return as of Sept. 30, 2017, was nearly 11% while five-year return was 14%.
‘Diversification can be a free lunch, but sometimes, like the last seven years, that lunch is only a ham sandwich compared to the filet mignon of mainstream portfolios.’
—Research Affiliates analysts Jim Masturzo and Jonathan Treaussard
Meanwhile, a globally diversified portfolio, returned less than 2% for both three-year and five-year periods.
So, why would anyone want to diversify?
Researchers Jim Masturzo and Jonathan Treaussard of Research Affiliates make the case that investing internationally and diversifying your portfolio might outweigh the risks of missing out.
“Diversification can be a free lunch, but sometimes, like the last seven years, that lunch is only a ham sandwich compared to the filet mignon of mainstream portfolios,” they wrote in a report from November 2017.
Diversification—the Research Affiliates analysts might argue—isn’t a tactical move (that is, employed when valuations abroad are relatively cheap as they are considered presently) but executed as a part of a broader investment strategy, and worth adhering to in any rational, long-term investment portfolio.
For example, since 2000, a blended, diversified strategy beat 60/40 portfolio, consisting of 60% U.S. equities and 40% of U.S. bonds, by 60 basis points, or 6/10ths of a percentage point, according to Research Affiliates.
So, why would anyone omit U.S. assets altogether in a portfolio that purports to be ideally mixed, and geographically distributed?
U.S. equities right now are richly valued, and having any allocation to this asset is suboptimal for future returns, Research Affiliates analysts write.
They plot the long-term real risk-and-return expectations for 27 global asset classes and six portfolios along the so-called efficient frontier.
The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk tolerance or the lowest risk for a given level of expected return. Anything below the curve is suboptimal, resulting in—for example—a lower return in exchange for higher risk. Anything to the right of the curve isn’t ideal either, pointing to even more elevated risks.
U.S. equities offer nearly flat annual average returns over the next 10 years, while volatility is at 15%. Although such average volatility is normal for U.S. equities, investors throughout this bull market have been accustomed to achieving double-digit returns.
To construct a portfolio that would have about 10% volatility, which authors of the note picked as “reasonable for an average investor” would therefore exclude U.S. equities altogether.
In fact, based on the efficient-frontier curve, a diversified portfolio would have allocated only 27.5% to global equities, given their perceived risk and potential long-term returns, as shown in the chart above.
Within global equities, two-thirds should be allocated to emerging markets and about 30% to Europe, Australasia and the Far East stocks.
The rest of the sample portfolio would be divided between bonds (25%), credit, including bank loans and emerging-market debt (13%), cash (7%), real estate (12.7%), private equity (7.3%) and commodities (5.3%).
“This outcome is not driven by a deep-rooted dislike of US companies. Rather, buying US equities at current high valuations sets up investors to “ride the wave” of “buy low, sell high” in the wrong direction,” researchers wrote.
Home bias, described as a tendency for investors to direct most of their investments in domestic assets, might make shunning U.S. stocks, at least for now, an unsettling proposition for skeptics.
Still, the strategies containing that discomfort can result in less volatile portfolios, if not richer returns.
“An important point for advisors and their clients is that by consciously constructing a blended portfolio, keeping tolerance to discomfort in check—as we have done in our example—we can increase the likelihood of willingly holding the portfolio over a longer horizon,” they wrote.
But, if allocating to U.S. stocks is what it takes to stay invested in a diversified portfolio, it is still a better solution than jumping in and out of investments at a wrong time, the analysts say.
The following chart illustrates how adding U.S. equities to a diversified portfolio, at this time, can weigh on potential returns.
Source: https://www.marketwatch.com/story/why-us-stocks-dont-belong-in-global-portfolionow-say-strategists-2017-11-07?mod=MW_story_latest_news


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