Welcome to Part 2 of the “Investing With Style: Opposites Attract” series. In part 1, I focused on the US stock market. Here in part 2, I will turn my focus towards international stocks.
It only seems right that if I am going to bring up the first of my two disagreements with Jack Bogle in the US Edition (Market-Cap Weighting), I should bring up my second here in the international edition: Foreign stock exposure.
I personally believe that even as a US investor, it is prudent to have a healthy allocation to international stocks. Bogle would argue that US companies get enough exposure to international markets via sales (They do get a sizable portion of revenue from overseas). The problem I have is that I do not know if the US stock market will continue its best in class performance this century and neither does Mr. Bogle. It could, but to bet my entire financial independence on it is a bit crazy to me. However unlikely, Japan is the perfect example of how big of a gamble this could be. They are approaching almost 3 decades now of close to 0% returns. I do not think this scenario is likely in the US, but it scares me enough to diversify globally.
Because of that, I wanted to explore style investing in foreign stocks and see what it has looked like in comparison to the US data from Part 1.
Lets go through the definitions for our international data before we explore the tables and charts:
- TSM = Total International Stock Market (Represented by the MSCI ACWI ex-USA Index from Jan 1995 through April 1996. VGTSX from May 1996 through December 2016)
- LG = International Large Cap Growth (Represented by VWIGX)
- SG = International Small Cap Growth (Represented by the Fama-French Global ex-US Small Cap Growth Factor Index)
- LV = International Large Cap Value (Represented by DFIVX)
- SV = International Small Cap Value (Represented by DISVX)
- LM = International Large/Mid Cap Momentum (Fama French Global ex-US Momentum Factor from Jan 1995 through May 1995 (Minus 30bps for Fund Fees). MSCI World ex-US Momentum Index from June 1995 to Jan 2015 (Minus 30bps for Fund Fees). IMTM ETF from Feb 2015 through Dec 2016.)
The time period we will be analyzing will once again be 1995-2016 (22 Years). As in the first post, let’s start with the individual style return characteristics over the time period:
The International Total Stock Market returned 4.61% over this period. Below its long-term average and a good amount below the 9.54% that the US TSM returned over the same period. Every style outperformed the TSM with the exception of Small Cap Growth. The Fama French data confirmed this. Unlike the US data, the international markets style performance matched the long term performance of these styles: SV > LV > LG > SG (“The Black Hole of Investing”). The positive styles had a higher relative premium in international markets compared to the US markets.
As expected, and similar to the US market, the Value and Momentum categories were adequately rewarded with higher returns and Sharpe ratios.
Here are the styles broken out by annual returns:
The first snapshot may have given it away, but the Value and Momentum categories were rewarded with very favorable “Best” to “Worst” year ratios, just like the US data. We should still point out that even though the TSM failed to keep pace with most of the styles, it still has a few positive traits for most investors:
- Second Lowest Volatility
- Relatively Low Max Draw-down
- No “Worst” Years
Let’s be serious though, we should just invest in Small Cap Value and go back to our lives right? Well, as we touched on in the US edition, if you have a iron-clad stomach, then sure. The issue as always though is that investing in 100% Small Cap Value has its own challenges, especially tracking error risk.
Once again, when I say tracking error risk, this is what I mean:
That’s right. After a four year period in the late 90s, your 100% Small Cap Value portfolio would be down 3%, while a simple index fund would have been up 49%. Even the most patient style investors would have thrown in the towel. This is why investing 100% of your portfolio in any single style is challenging. Forget returns and think about your behavior. That should be the most important aspect when building your portfolio.
Can you stick with it?
Here is the annual tracking error of all five styles:
When a cell is highlighted in orange, it means that the annual tracking error for that style was negative in comparison to the TSM Fund for that year. When a cell is highlighted in red, it means that the annual tracking error for that style was over -5% in in comparison to the TSM Fund for that year.
Essentially, the orange cells represent years that most investors would probably become slightly frustrated. The red cells represent years that most investor would become very frustrated. Few investors would bail after one of those years, most would bail after two in a row or two years in three (i.e. Value in the late 90s and Growth in the mid 2000s).
When we take a deeper look, it starts to become clear that investing solely in a Small-Cap Value strategy over this period would have been difficult. Sure the returns were the highest, but the strategies volatility was very high AND the tracking error was extreme in a number of years (It had the second highest number of extreme tracking error years; 6). When we boil it down, an investor who stuck with the small-cap value strategy through all of that madness was rewarded for it. The problem is that during the madness, there was no guarantee of the styles success in the future. The Small-Cap Value investor could rely on nothing but faith. And so, the question we have to ask ourselves is:
Could we realistically hold-on to a portfolio that performed like that?
Some will say yes, but most people couldn’t do it.
Note: There was not a single year where both SV and LM had negative tracking error. If you go back to the US Edition, you will find the same thing…
This leads us to what the correlations look like between these styles:
Note: As a refresher, a correlation of 1 would mean that the two styles move together every month. A correlation of -1 would mean that the two styles move in the opposite direction every month.
Naturally, since everything on this table has its main exposure to the International Stock Market, the correlations will all be somewhat high (Close to 1).
The one that sticks out right away is the correlations between LM / SV (0.73). Everything else seems to hover in the 0.80-0.90 range, higher than what we saw with the US styles, but none of this is unexpected. One other interesting find is the correlation between LG / LM (0.87) as this could be used to swap those styles for each other when testing possible portfolios.
To save you and me a bunch of time, I am going to present the same tables above, but replace single styles with potential portfolio mixes that I came up with.
We will be using the same portfolio mixes from the US Edition. Here is our first snapshot:
A couple things should stick out right away:
- Every portfolio mix beat the TSM Fund over the 1995-2016 period in terms of return.
- Every portfolio had a higher Sharpe than the TSM Fund meaning that over this time period, we were rewarded for taking on more “risk” (Volatility).
Similar to what we found in the US over this time period, we would have been rewarded for getting away from a 100% Market Cap Weighted portfolio…assuming you could have stuck with your portfolio.
Here is the full table with the annual returns:
There are some differences in the international data set compared to the US version. From a negative experience standpoint, the Large-Cap Growth / Small-Cap value portfolio gave the best results with 0 “Worst” years. Back to the similarities of the US data, the two portfolios that included a mix of Momentum and Value produced the highest Sharpe ratios (And the lowest Volatility).
Here is one last way to look at the returns:
We know that looking backwards some mix of Momentum and Value was a great strategy based on the risk/return data, so lets find out how it would have felt from a behavioral standpoint. The question always comes back to, “Would we have been able to realistically see those returns?”
Much like the US data, the portfolios exposed to Momentum had the lowest and second lowest number of negative tracking error years (6 and 8) AND the lowest and second lowest number of bad tracking error years (1 and 2). They also had the lowest average negative tracking error in the years that those portfolios under-performed. This is great news.
Lets look at this from one other angle:
From this angle, we see a similar story. The portfolios that contained Momentum with Value, show the lowest average under-performance in negative periods.
Once again, it seems that this combination of Large-Cap Momentum and Small-Cap Value has some legs. It seems to check all of our investment ideals:
- Strong Returns
- Comparable Risk to a TSM Approach
- Increased Sharpe
- Stomach-able Behavioral Challenges
- Rather Simple Strategy (2 Funds to implement)
It also has examples of working in shorter random periods:
Will this strategy always work over 1, 3, 5, 7, 10 year periods? Of course not, but it clearly has some validity when thinking about how to allocate money into the stock market, especially for those who struggle with Market-Cap weighting (Me!).
Now I wanted to step away slightly from the Momentum and Value discussion for one quick note on international diversification tangent. If you guessed that I would bring up Japan again, take a drink. Most people know the story, but it is still the strongest argument for geographic diversification I have ever read about. There are others, like full market closures in other countries (China for example), but Japan is a great example for two main reasons:
- The period that this happened in was very recent. The data I looked at was from 1996-2016
- Japan is considered by anyone to be a very developed nation that has modern laws, regulations and transparency.
Take a look at the following table of equity returns in Japan from 1996 through 2016:
Now there are still many differences between Japan and the US, and because of those differences, I do not see what happened in Japan to be a likely outcome in the US in our lifetimes, but even if there was a 0.5% chance of this happening in our lifetime, international diversification, even something like 20% of equities, becomes very worth it.
I think there are still a large number of people that invest in US Stocks and just expect to earn something around 8-10% a year in their lifetime. Now this is certainly the smarter bet to make, but we need to consider the possibilities of other outcomes. For me, investing in global stocks (Anywhere from 30%-60% of equities) is the prudent strategy. Disagreeing with Bogle and Buffett is not the wisest thing to do, but I know enough to know that no one, not even the giants of the investing world, can predict the future.