Revisiting International Allocations Within the Modern Portfolio Theory Framework

FEATURE | Revisiting International Allocations within the Modern Portfolio Theory Framework

Revisiting International Allocations within the Modern Portfolio Theory Framework

By Benjamin Doty, CFA®, and Will Olinger, CIMA®

key question for asset allocators, bias. Among institutional investors, rec- Historical evidence suggests that an inter- among others, is how to allocate ommendations vary widely with no con- national allocation can reduce volatility A stocks among domestic and foreign sensus. In the Barron’s Penta survey of 40 without significantly impacting Sharpe equities. U.S.-based investors often express wealth management firm asset allocations ratios, but the required allocation over a a strong home bias versus the investable (Hube 2016), City National Rochdale long period is not high. Periods of outper- universe, most often expressed with an recommended an 85-percent allocation formance by international stocks, however, index such as the MSCI ACWI Investable to U.S. equities, whereas Morgan Stanley/ can justify an ex-ante increase in an alloca- Market Index (IMI). A neutral position in Smith Barney recommended only a tion that changes over time. this investable universe would dictate an 40-percent allocation to U.S. equities. allocation of approximately 53 percent to The State Board of Administration of Historical Evidence the United States, 36 percent to foreign Florida, which manages $148 billion, had A full 40-year comparison of the perfor- developed markets, and 11 percent to only 48 percent of its global equity portfo- mance of U.S. stocks to international stocks emerging markets. According to the 2015 lio directly in U.S. stocks as of the end shows that volatility can be reduced by an Investment Company Factbook, of the 56 of its 2015 fiscal year. In contrast, the international allocation as high as percent held in equities in a total portfolio New York Common Retirement Fund 40 percent (see figure 1). Risk-adjusted per- consisting of all U.S. mutual funds and with $178 billion in assets as of March 2016 formance, as measured by the Sharpe ratio, exchange-traded funds (ETFs), 42 percent had 35 percent invested in U.S. equities however, shows no value added (figure 1). of the total portfolio was in domestic versus 13 percent abroad, which translates An allocation of 10–20 percent to interna- stocks, leaving only 14 percent invested into a 65-percent allocation to U.S. stocks tional stocks can modestly reduce volatility abroad. In other words, typical U.S. inves- in its global equity portfolio. Even among without significantly changing the Sharpe tors held only 25 percent of their equity the largest institutional investors there may ratio. This sweet spot approximates what assets in foreign equities, clearly a home not be much consensus. the average fund investor currently allo- cates to stocks listed overseas. The more Figure 1: Change in Portfolio Volatility (1975–2016) recent 20-year history, however, shows more home bias. The benefits of reduced 2.00 0.00 volatility end at a 20-percent allocation to international stocks (see figure 2). −0.02 1.50 −0.04 The longest history of available international

1.00 −0.06 Change in Sharpe Ratio data, however, includes only listed stock performance of mostly developed-market coun- −0.08 0.50 tries. The MSCI Emerging Markets Index −0.10 was created in 1988, for example, and it has 0.00 since undergone a series of dramatic −0.12 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% changes. It started with only 10 constituents −0.50 −0.14 representing only 1 percent of global market

Change in Portfolio Volatility (%) capitalization and now represents 23 coun- −0.16 –1.00 tries and more than 10 percent of market −0.18 capitalization.1 The MSCI ACWI ex USA

−1.50 −0.20 Index, versus the older MSCI World ex USA Index, includes emerging markets to pro- Change in Portfolio Volatility Change in Sharpe Ratio vide a richer point of view. But when MSCI

48 INVESTMENTS&WEALTH MONITOR

ACWI ex USA is used instead of MSCI Figure 2: Change in Portfolio Volatility (1996–2016) World ex USA to represent the international allocation it affirms the home bias even 1.80 0.00 more strongly. In addition to a decrease in the Sharpe ratio, there is an increase in port- 1.60 folio volatility, due to the higher risk of 1.40 −0.05 emerging-market stocks and higher correla- Change in Sharpe Ratio 1.20 tion between U.S. and international stocks (see figure 3). 1.00 −0.10 0.80 Looking at historical periods that cov 0.60 −0.15 ered more than one U.S. market cycle (15–40 years), it’s easy to see how inves- 0.40 tors might choose a strong to full home Change in Portfolio Volatility (%) 0.20 −0.20 bias if they searched for a minimum- 0.00 variance portfolio, as defined by the high- 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% est Sharpe ratio. Two factors, however, −0.20 −0.25 argue against a full home bias. Emerging- Change in Portfolio Volatility Change in Sharpe Ratio market stocks can expand the opportunity set (when considering the longer history Figure 3: Change in Portfolio Volatility (2001–2016) using the MSCI ACWI of price returns), and, more importantly, ex USA Index there are periods well beyond the tactical periods of 12–24 months when interna- 3.50 0.00 tional stocks outperform U.S. stocks. If the 3.00 choice of measurement for the inputs in a −0.02 minimum-variance optimization (MVO) coincide with a period of outperformance 2.50 Change in Sharpe Ratio −0.04 by international stocks, MVO analysis will favor more international stocks, and vice 2.00 versa. This often makes recent historical −0.06 inputs into the modern portfolio theory 1.50 (MPT) framework favor U.S. stocks and, −0.08 hence, possibly problematic. 1.00

Change in Portfolio Volatility (%) −0.10 Thinking in Shorter Intervals 0.50 Where developed international stocks don’t 0.00 −0.12 add to the Sharpe ratio, or reduce volatility, 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% emerging-market stocks may have a place Change in Portfolio Volatility Change in Sharpe Ratio that expands the opportunity set and, hence, the overall efficient frontier of investment opportunities going forward. International stocks, moreover, have had valuations, do make a difference. Moving We emphasize the word “may” here multi-year periods of outperformance to from ex-post observations to ex-ante because the data aren’t as long as they are U.S. stocks. When considering rolling three- expectations of returns may, therefore, have for developed-market stocks. In the past year returns (annualized), an investor with merit in an asset allocation process if the 15 years or so, the best absolute returns in international stocks would have outper- time horizon for an allocation lies within foreign markets have come from emerging- formed U.S. stocks during four distinctive the intermediate to long-term. market stocks (see table 1). This should not periods since 1972 (see figure ).4 The blue go unnoticed. In fact, a two-asset portfolio bars represent periods of U.S. (S&P 500 Ex-Ante International Allocations of only U.S. stocks and emerging-market index) outperformance, whereas those in The literature is mixed on which measures stocks, while increasing volatility, can red represent periods of U.S. underperfor- are the best predictors of long-term returns. increase the Sharpe ratio meaningfully mance. Not surprisingly, these four periods Yale economist Robert Shiller, along with from 0.39 to 0.44 with a 40-percent alloca- start at the tail-end of technical bear mar- his colleague, demonstrated the predictive tion to emerging markets historically back kets in the United States, which seems to ability of his cyclically adjusted-price-to- to 2001. suggest that valuations, specifically relative earnings (CAPE) ratio for long-term

JANUARY / FEBRUARY 2017 49

Table 1: U.S. and International Returns—Various Indexes

1998 1999 2000 2001 2002 2003 2004 2005 2006

MSCI EM NR S&P 500 TR MSCI EM NR MSCI EM NR MSCI EM NR MSCI EM NR MSCI EM NR MSCI EM NR MSCI EM NR USD USD(1936) USD USD USD USD USD USD USD

MSCI ACWI Ex MSCI EAFE S&P 500 TR MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI Ex USA NR USD NR USD USD(1936) USA NR USD USA NR USD USA NR USD USA NR USD USA NR USD USA NR USD

MSCI EAFE MSCI ACWI MSCI ACWI MSCI EAFE MSCI EAFE MSCI EAFE MSCI EAFE MSCI EAFE MSCI EAFE NR USD NR USD NR USD NR USD NR USD NR USD NR USD NR USD NR USD

MSCI ACWI MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI MSCI ACWI MSCI ACWI MSCI ACWI MSCI ACWI MSCI ACWI NR USD USA NR USD USA NR USD NR USD NR USD NR USD NR USD NR USD NR USD

S&P 500 TR MSCI EM NR MSCI EAFE S&P 500 TR S&P 500 TR S&P 500 TR S&P 500 TR S&P 500 TR S&P 500 TR USD(1936) USD NR USD USD(1936) USD(1936) USD(1936) USD(1936) USD(1936) USD(1936)

2007 2008 2009 2010 2011 2012 2013 2014 2015

MSCI EM NR S&P 500 TR MSCI EM NR MSCI EM NR S&P 500 TR MSCI EM NR S&P 500 TR S&P 500 TR S&P 500 TR USD USD(1936) USD USD USD(1936) USD USD(1936) USD(1936) USD(1936)

MSCI ACWI Ex MSCI ACWI MSCI ACWI Ex S&P 500 TR MSCI ACWI MSCI EAFE MSCI ACWI MSCI ACWI MSCI EAFE USA NR USD NR USD USA NR USD USD(1936) NR USD NR USD NR USD NR USD NR USD

MSCI ACWI MSCI EAFE MSCI ACWI MSCI ACWI MSCI EAFE MSCI ACWI Ex MSCI EAFE MSCI EM NR MSCI ACWI NR USD NR USD NR USD NR USD NR USD USA NR USD NR USD USD NR USD

MSCI EAFE MSCI ACWI Ex MSCI EAFE MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI MSCI ACWI Ex MSCI ACWI Ex MSCI ACWI Ex NR USD USA NR USD NR USD USA NR USD USA NR USD NR USD USA NR USD USA NR USD USA NR USD

S&P 500 TR MSCI EM NR S&P 500 TR MSCI EAFE MSCI EM NR S&P 500 TR MSCI EM NR MSCI EAFE MSCI EM NR USD(1936) USD USD(1936) NR USD USD USD(1936) USD NR USD USD

very close to its historical earnings yield. Figure 4: Rolling Three-Year Outperformance of U.S. Stocks (since 1972) If we consider where valuations stand now, 20.00% based on the inverse of current P/E multi- ples, therefore—ignoring inflation for ease 15.00% of calculation, it is clear that an argument can be made for the relative expensiveness 10.00% of U.S. stocks and the lower, corresponding prospect for future returns. (See table 2 for 5.00% an example of two third-party return 0.00% expectations alongside the earnings yield.)

−5.00% If we assume that correlations will remain high and historical volatility will not −10.00% change much, the inclusion of expected returns in place of historical returns will −15.00% not reduce volatility, but it will improve

−20.00% risk-adjusted returns as the international allocation increases (see figure 5). This is 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 not surprising, given that slight changes in expected returns can have significant returns (Campbell and Shiller 1988), and methods may be superior. Its simplicity results on MVO outputs, the most among many other researchers and practitioners makes it a straightforward predictor of the three components of capital markets have documented the same historical find- future return. It is also intuitive. It is the expectations. ings in other countries. Mebane Faber’s amount paid for each dollar of earnings. work in the Journal of Indexes is one exam- It is also well-documented that high price- Marrying MPT Process ple (Faber and Dalmia 2013). to-earnings (P/E) ratios generate poorer with Judgment stock market performance in the long- Constraints are nearly an inevitable part of We can consider earnings yield as an term (Shen 2000). As Jeremy Siegel has setting the international allocation in a approximation of future expected returns explained in Stocks for the Long Run, the framework built on MPT. These constraints in the long-term, even though other average real return of U.S. stocks has been can be guided by statistical outputs from

50 INVESTMENTS&WEALTH MONITOR

historical and expected capital market Table 2: Various Long-Term Expected Return Assumptions observations, but the constraints often will fall on the judgment of the investor Research Affiliates JP Morgan Earnings Yield Forecast or investment committee. Ranges around U.S. 3.3% 6.25% 5.02% a target allocation, therefore, are ever more International 8.3% 7.25% 6.76% important. Ex-ante assumptions, built on Research Affiliates Asset Allocation website. Accessed December 9, 2016, https://www.researchaffiliates.com/en_us/ sound expectations, however, can help asset-allocation.html. U.S. stock returns proxied by U.S. large real returns plus 2.3-percent inflation. International stock returns proxied by EAFE Equity (80 percent) and EM Equity (20 percent) real returns plus 2-percent inflation. determine where to fall within that range JP Morgan’s 2017 Long-Term Capital Market Assumptions, Investment Insights. U.S. stock returns proxied by U.S. of how much to invest in stocks abroad. large-cap compounded returns. International stock returns proxied by EAFE Equity (80 percent) and Emerging Mar- kets Equity (20 percent) returns. Earnings yield forecast uses the earnings yield of the S&P 500 index for U.S. returns, and international returns use the Within the very components of MPT, as earnings yield of the MSCI ACWI ex USA index. well—expected return, standard deviation, and correlation—are the keys to improving Figure 5: Change in Portfolio Volatility (using the Earnings Yield) international stock returns. Various factor exposures can improve expected return, 2.00 0.12 and seeking low-volatility investments improves the standard deviation of interna- 1.80 0.10 tional assets. 1.60 Change in Sharpe Ratio 1.40 Benjamin Doty, CFA®, is senior investment 0.08 director at Koss Olinger and Company in 1.20 Gainesville, FL. He earned BA and MBA 1.00 0.06 degrees from the University of Georgia. Contact him at [email protected]. 0.80 0.04 0.60 William D. Olinger III, CIMA®, is managing Change in Portfolio Volatility (%) 0.40 partner with Koss Olinger and Company in 0.02 Gainesville, FL. He earned a BA in economics 0.20 from Wake Forest University. Contact him at 0.00 0.00 [email protected]. 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Change in Portfolio Volatility Change in Sharpe Ratio Acknowledgments The authors express appreciation to Chandler Norder, investment intern at Koss Endnote www.barrons.com/articles/asset-picks-from-top- 1. See the MSCI website at https://www.msci.com/ wealth-management-firms-1458959882. Olinger and Company, for his help with emerging-markets. Last accessed December 12, 2016. Faber, Mebane, and Prabhat Dalmia. 2013. Global Value gathering data for this article. and 10-Year CAPE. Journal of Indexes 16, no. 2 (March/ References April): 16–21. Siegel, Jeremy J. 2014. Stocks for the Long Run, 5th Campbell, John Y., and Robert J. Shiller. 1988. Stock Appendix edition. New York: McGraw Hill. Prices, Earnings and Expected Dividends. Journal of Shen, Pu. 2000. The P/E Ratio and Stock Market Finance 43 no. 3 (July): 661–676. Table A1 shows the assumptions made in Performance. Economic Review Q IV. The Federal Hube, Karen. 2016. Asset Picks from Top Wealth Reserve Bank of Kansas City: 23–36. the construction of figures 1, 2, 3, and 5. Management Firms. Barron’s Penta (March 26). http://

Table A1: Underlying Figure Assumptions

Figure 1 Figure 2 Figure 3 Figure 5 Return (U.S.) 11.42% 7.66% 6.88% 5.02% Return (International) 9.01% 4.41% 6.27% 6.76% Standard Deviation (U.S.) 15.29% 15.36% 14.44% 10.82%* Standard Deviation (International) 16.71% 16.92% 17.59% 12.67%* Correlation 0.57 0.85 0.87 0.84 MSCI World MSCI World MSCI World International Index N/A Ex USA USD Ex USA USD Ex USA USD

* Three-year standard deviation

JANUARY / FEBRUARY 2017 51