PERSPECTIVE3-5 min to read

The regime shift underway may bring favorable tailwinds for active international equity investors

Market breadth and inefficiencies may favor active managers.

21/03/2024
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US equities have been on an extended run, outperforming international equities in 8 of the last 10 years and delivering an annualized outperformance of more than 8% during the past decade.1 But, over the long term, market leadership is usually cyclical, so it’s worth maintaining a meaningful allocation to stock opportunities outside the United States. Further, for many US investors, the exposure they get to non-US equity markets is through passive strategies. But the inefficiency of international markets and the track record of active managers demonstrate the potential value of keeping at least a portion of a portfolio’s international allocation with a manager who can exploit the opportunities and effectively mitigate the risk these markets present.

Following are seven reasons why investors may want to take a closer look at their current equity allocations and consider whether they’re properly positioned for the opportunities that could arise in a changing global economic climate.

1. Most US institutions are now underweighted to international equities.

Most asset allocation models suggest 30%-40% of a US investor’s equity allocation should be in international equities. A recent survey of institutional investors shows that the average international allocations of most institutional equity portfolios are now 20%-30%, with corporate defined benefit and Taft-Hartley plans notably at the low end of that range.2 Currency fluctuations and geopolitical tensions might have provided the rationale for being more US-centric, but amid the economic regime shift we call the 3D Reset – led by the trends of deglobalization, demographics and decarbonization – many of the conditions that drove the significant outperformance of US equities are changing.

2. 80% of the world’s stock opportunities are outside the US while the public equity opportunities in the US continue to decline.

Of the world’s more than 55,000 listed companies, 45,000 are outside the United States.3 Non-US stocks’ share of the global opportunities has increased, given that the numbers of public companies in the US has declined while the number of public companies overseas has continued to rise. Excluding over-the-counter stocks and considering just the companies traded on exchanges, the number of publicly listed US companies has dropped by more than 50% since 1996, declining from more than 8,000 to 3,700 in 2023.4

3. International markets are inefficient because fewer analysts cover these companies, and that increases the potential opportunities for active investors to beat the market.

Among the companies in the S&P 500 Index, 99% are covered by three or more analysts.5 By contrast, globally, only 50% to 75% of the developed market countries have that much coverage for their listed companies.6 Depending on the country, those numbers can go as low as 15% to 46%. For Japan, only 46% of the companies in the Tokyo Stock Price Index (TOPIX) are covered by three or more analysts.

Less coverage often creates more inefficient markets. That may help explain why three-quarters of active large cap international equity managers beat their benchmark for both the past 5 years and 10 years (through year-end 2023) even after fees. (See Figure 1.)

Figure 1: A large majority of active managers beat the benchmark

Percentile ranking of the MSCI ACWI ex US relative to active strategies for the past 5 and 10 years, as of 12/31/23

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Source: eVestment Alliance, LLC and its affiliated entities (collectively “eVestment”) collect information directly from investment management firms and other sources believed to be reliable, however, eVestment does not guarantee or warrant the accuracy, timeliness or completeness of the information provide and is not responsible for any errors of omissions. Performance results may be provided with additional disclosures on eVestment’s systems and other important considerations such as fees that may be applicable. Not for general distribution may only be made pursuant to client’s agreement terms. All categories necessarily included. Totals may not equal 100%. Copyright 2012-2024 eVestment Alliance, LLC. All rights reserved. Past performance is no guarantee of future results and may not be repeated.

4. For most active international equity managers, the scale of outperformance has gone well beyond the average active management fees.

The median large cap international equity manager has delivered roughly 1.0%-1.5% of excess return over the past 3-, 5- and 10-year periods versus the benchmark, while the median US large-cap manager underperformed the benchmark by 0.5%-1.0% over the same periods. (See Figure 2.) In fact, over the trailing 5-year period the benchmark ranked in the 88th percentile and lagged the third quartile by 0.89%. When you consider management fees, which are typically in the range of 50-70 basis points for most international equity mandates and 5-10 basis points for passive strategies, more than 75% of the active managers would have still beaten the benchmark on a net-of-fees basis.

Figure 2: Active managers of international and emerging market strategies have a good track record for delivering excess returns

Annualized excess returns achieved by the median active manager for each category

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Source: Schroders, eVestments, MSCI, S&P as of December 31, 2023. Annualized excess returns for International Equities, represented by the median return within the eVestment Non US Large Cap Equities Universe minus the MSCI ACWI ex USA Index. Excess returns for Emerging Markets represented by the median return within the eVestment Global Emerging Markets Equity Universe minus the MSCI Emerging Markets Index. Excess returns for US Small Cap represented by the median return within the eVestment US Small Cap Equity Universe minus the Russell 2000 Index. Excess returns for US Large Cap represented by the median return within the eVestment Large Cap Equity Universe minus the S&P 500 Index. Past performance is no guarantee of future results and may not be repeated.

Even the international equity managers in the third quartile for performance beat the MSCI ACWI ex USA Index by over 50 basis points (bps) annualized over a 10-year period. The top quartile of managers have delivered excess returns in the range of 200-400 bps over the 3-, 5-, and 10-year periods. Those numbers are even higher for emerging markets and small-cap manager versus their relevant benchmarks. Passive investors may be leaving at least 50 bps of annualized excess return on the table, provided they select managers in the top 75% (based on performance through 2023).

5. Selection is incredibly important in a highly diverse market, and individual international markets – and companies – often deliver exceptional performance.

International and emerging markets are not a homogenous asset class. The drivers of the companies, industries and countries across the world are very different. Markets such as India, Mexico, Denmark, Italy and Spain have been equally strong (or even stronger) than the US over the past 3 years in US dollar terms.7 While the US stocks known as the “Super 7” get all of the attention in 2023, it is important to remember that, on average, 9 of the top 10 best performing global-stocks each year over the past 10 years have been non-US equities.8

6. The tide may be about to turn: The cycle of outperformance for US vs. international stocks often tracks the strength of the US dollar, and a weakening (or even stable) dollar could signal a turning point in the cycle.

The conditions that led to the extended strength of US stocks have changed. We believe that the dollar has likely peaked for the cycle, with the Federal Reserve having paused its tightening cycle amid slower US economic growth and tighter financial conditions. A weaker dollar has historically been associated with strong international equity performance because a weaker dollar means more purchasing power for local consumers around the world.

Figure 3: The cycle of US versus international equities outperformance has historically tracked the performance of the US dollar

US equity vs. international equity – 5-year monthly rolling returns (annualized) since 1976

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Source: Schroders, MSCI, Refinitiv Datastream. Data to December 30, 2023 since January 1976. US Equity is represented by the S&P 500 Index (price index). International Equity is represented by MSCI World ex US Index (price index). The chart shows the value of the S&P 500 Index’s returns (5-year monthly rolling returns annualized) minus the MSCI World ex USA Index’s returns. When the line is above 0, US stocks outperformed international stocks. When it is below 0, international stocks outperformed. The green line is the performance of the US Dollar Index (DXY) performance on the basis of 5-year monthly rolling returns annualized. Past performance is no guarantee of future results and may not be repeated.

Emerging market economies with dollar-denominated debt typically benefit most from a weaker US dollar. The yen, euro and pound all stand near multi-decade lows, which means that goods produced in those markets are generally more cost competitive. As Figure 4 shows, earnings in Europe ex UK and Japan have been as good or better than earnings in the US over the past decade.

Figure 4: Japanese and European companies have grown their earnings at a similar – or faster – rate than their US counterparts over the past decade.

Return attribution for the past 10 years per year (as of 12/31/23)

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Past performance is not a guide to future performance and may not be repeated. Figures do not sum exactly because they have combined geometrically rather than arithmetically. e.g. US total return = (1+price return) x (1-dividends) = 1.099 x 1.019) – 1 = 12.0%. Data to 12/31/2023. Sources LSEG Datastream, Schroders.

Yet the valuation discount for international stocks, relative to US stocks, soared to a record high by the end of 2023 (see Figure 5).

Figure 5: The valuation gap between stocks in the US vs. the rest of the world is at a record high

2024 consensus S&P price-to-earnings ratio (P/E) minus MSCI ACWI ex US P/E

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Source: Bloomberg. Current performance trends are not a guide to future results and may not continue.

The substantial outperformance by US stocks has been driven largely by the strength of the dollar, US stock buybacks and valuation re-ratings. If earnings in other markets remain stable or even accelerate relative to the United Sates, it will become harder to argue for their continued significant valuation discount relative to US stocks.

7. Active managers can provide risk management that passive strategies don’t.

Investing internationally through passive strategies provides risk exposures many investors may not want. Six percent of the ACWI ex US is in China, for example, and the Chinese government is increasingly – and often unpredictably – interfering in the private sector and limiting the returns foreign investors in Chinese stocks can realize. A changing regulatory environment – like new carbon disclosure requirements starting in 2023 and a new carbon border adjustment tax coming to the European Union and United Kingdom in 2026 – will increase costs and impact earnings. Active managers will be best positioned to navigate these and other potential regulatory changes that may impact companies’ earnings power. International equities are not a market investors should have blind exposure to, yet over 41% of institutional assets – more than $1 trillion – is in passive strategies.9

Conclusion: The potential for considerable return and risk management benefits

International equity shouldn’t be viewed simply as a beta bucket. While passive can play an important role in managing liquidity, US institutional investors may be losing a significant source of excess return within their portfolios if their international exposure is entirely passive. Putting at least a portion of an international allocation into actively managed strategies has the potential to deliver considerable return and risk management benefits.

Endnotes:

1 Source: Schroders, MSCI, Refinitiv Datastream. US Equity is represented by the S&P 500 Index (price index). International Equity is represented by MSCI World ex US Index (price index). Past performance is not a guarantee of future results.

2 Source: The Callan Database Group

3 Source: “Stock Exchanges Around the World,” Investopedia, 1/31/24

4 Source: “America has lost half its public companies since the 1990s. Here’s why,” CNNBusiness.com, citing the Center for Research in Security Prices, 6/9/23 

5 Source: JPMorgan

6 Source: JPMorgan

7 Based on the returns for the constituents of the MSCI All Country World Index as of 12/31/23.

8 Based on the calendar year returns for the MSCI All Country World Index for the past 10 years sorted by constituent performance for the top 10 best-performing stocks, as of 12/31/23

9 Source: eVestments, as of 12/31/23. Based on total institutional assets under management within the eVestment non-US Equity universe.

Important Information

All investments, domestic and foreign, involve risks including the risk of possible loss of principal. The market value of the portfolio may decline as a result of a number of factors, including adverse economic and market conditions, prospects of stocks in the portfolio, changing interest rates, and real or perceived adverse competitive industry conditions. Investing overseas involves special risks including among others, risks related to political or economic instability, foreign currency (such as exchange, valuation, and fluctuation) risk, market entry or exit restrictions, illiquidity and taxation. These risks exist to a greater extent in emerging markets than they do in developed markets.

The views shared are those of the author. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice. Information herein has been obtained from sources we believe to be reliable but Schroders Plc does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. Past performance is no guarantee of future results.

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