Performance Considerations: Diversification and Benchmarks
January 31, 2022. By J.D. Wolfsberg:
In covering the financial markets, the media often focuses on three prominent market indices; ‘The Dow’ ‘The S&P 500’ and the ‘Nasdaq’. These popular indices represent large cap stocks and are dominated by names such as Apple and Microsoft.
When looking at an equity portfolio managed by an advisor or an allocation fund manager, an investor would likely notice that the performance of the equity allocation will differ from the performance of the major indices focused on by the media. This will happen because a professional manager will not only focus on diversification with different stocks in the portfolio, but they will also diversify amongst different equity sub-asset classes such as small capitalization stocks, mid-capitalization stocks, and international stocks.
Over the last decade, the large capitalization indices have been the outperformers, specifically led by mega-cap tech stocks such as those mentioned in the first paragraph. This has helped vindicate U.S investors that tend to have a home bias. Being invested in the names of stocks we are familiar with can offer comfort, especially during periods where volatility picks up. However, there are some points to consider:
The Case for International Stocks
It has been a relatively rough decade for international stocks when being compared to large cap U.S. stocks. However, periods of international outperformance have occurred in cycles throughout history. While it may seem like a distant memory , if we look at the period from 1/1/2002 – 12/31/2011, we can see that international stock markets outperformed U.S. large cap stocks substantially. Developed markets and emerging markets returned an annualized +4.67% and +13.86% respectively relative to the S&P 500 which had an annualized return of +2.92%.
Another point to consider is that while many U.S. investors may have a bias to overweight U.S. domiciled stocks, doing so may limit allocations to quality companies outside of the country. If we consider the Vanguard Total World Stock Index ETF, which tracks the FTSE Global All-Cap Index, it essentially holds every investable stock in the world and weights them by market capitalization. This serves as a great gauge for the global equity market. Even with the run-up in relative U.S. equity valuations over the last decade – the U.S. still only accounts for 60% of the allocation of this ETF. Investors who invest solely in U.S. stocks are missing a big piece of the equity markets!
The Case for Small/Mid Cap Stocks
During the same period referenced for international stocks (1/1/2002 – 12/31/2011), the Russell 2000, which tracks 2,000 small cap companies, returned an annualized +5.62% vs. the S&P 500 posting a +2.92% annualized return. The last ten years paint a different picture as the Russell 2000 underperformed the S&P 500 (+13.23% annualized return vs. +16.55% annualized return in the period from 1/1/2012 – 12/31/2021).
Different periods within the economic cycle have historically favored small cap stocks relative to large cap stocks. Historically, small cap stocks have outperformed coming out of recessionary periods as investors begin to price in higher growth. We saw this in 2020, when the Russell 2000 recovered from the Q1 sell-off and returned +19.96% on the year vs. the S&P 500 which had a calendar year return of +18.40%.
Strategic Diversification vs. Market Timing
Historically, different parts of the equity market have gone through phases of outperformance. Over the last ten years, we have seen U.S. large cap stocks outperform almost every other corner of the equity market and propel markets to new highs. Even though in hindsight there are always signs of why a performance regime changed, trying to anticipate when that will happen is extraordinarily difficult. What most investors end up doing is performance chasing and allocating to an asset class after it has outperformed hoping the outperformance will continue.
The more prudent approach is to work with a professional to develop an appropriate asset allocation that will provide diversification and exposure to different equity asset classes so that when performance regime shifts do occur, there is participation. Consider the following chart sourced from Morningstar:
As previously discussed, it is clear in the first decade that international stocks (represented by the MSCI EAFE and MSCI EM Indices) outperformed the U.S. Markets. At the conclusion of 2011, U.S. markets (especially large caps represented by the S&P 500) began to outperform international stocks. Obviously in hindsight, this would have been the perfect time to pivot completely from international stocks to U.S. stocks, however, history has shown that few if any investors have been able to do this consistently.
A more prudent approach is to develop a diversified equity portfolio. The Vanguard Total World Stock Index ETF, with a 40% allocation to international stocks, may prove to have a heavier allocation to international stocks than most U.S. based investors are comfortable with, but what if we looked at a diversified portfolio with half of that international allocation? This achieves diversification but allows the U.S. investor to remain overweight in the Apple’s and Microsoft’s that are so popular in their domestic markets. The following chart is the same chart listed previously, except it includes a hypothetical Diversified Equity Portfolio with a 20% allocation to international stocks. This hypothetical Diversified Equity Portfolio within its U.S. allocation includes a 70/30 breakdown between U.S. large cap and small/mid cap stocks which is approximately the weight of most U.S. total stock market indices. This weighting is appropriate within the hypothetical portfolio as it is reflective of the relative weights of the U.S. stock market:
As we can see through the first decade, the S&P 500 underperformed and the allocations to small/mid cap stocks and international equities contributed to the performance of the Diversified Equity Portfolio . Then when the regime shifted in the most recent decade where large cap stocks outperformed, the portfolio still highly participated in this growth.
When working with a professional advisor, part of their role is to develop an allocation that will allow for diversified participation regardless of what equity sub-asset class outperforms. These performance regime changes can occur suddenly, so trying to time the market when making an allocation shift is not an investment strategy that we would recommend. Investors should keep this in mind when assessing their investment performance and reviewing their allocations.
The information and analysis expressed herein is for general and educational purposes only and is not intended to constitute individualized investment advice. Recommendations contained herein, if any, may not be suitable for all investors and should not be relied upon by the reader as research or investment advice regarding any security in particular. You should make your investment decisions based on your personal financial goals and the reward/risk level with which you feel comfortable. Investing involves risk, including the potential for loss of principal. Past performance does not guarantee future results. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. The information contained herein has been prepared in part on third-party sources believed to be reliable, but there can be no guarantee as to its accuracy or completeness. Please consult Centerpoint Advisors, LLC about your investment needs, investment objectives, risk tolerance and any changes in your life that may impact your financial objectives.