Buying The S&P 500 Today? Wait. These 7 Graphs Show What You May Miss
The Definitive Guide to Equity Index Investing - PART 5
This article is Part 5 of our definitive guide to Equity Index Investing.
As portfolio managers, we are constantly reminded of changes in the world’s economy. Yet, our minds tend to resist change. Especially, when we have an emotional attachment to a country.
Over the past 20 years, I visited most of the U.S. States. I spent time at NYU and joined a prestigious Wall Street Graduate Programme in the late 2000s. I was impressed by Silicon Valley. But while cycling the world, I was confronted with realities that I previously underestimated. This century may not belong to America.
Here are risks and opportunity costs to consider by concentrating your investments. Even in the strongest country, like the U.S.
KEY TAKEAWAYS
- Over the past 50 years, the US Market outperformed the Rest of the World by 1% annually. But all of it came in the last 8 years.
- Compared to the S&P 500, a more diversified Global Portfolio has lower volatility and increases the likelihood of financing your projects.
- Your expected returns depend on the starting point. US Markets are, by historical standards, expensive.
- In the past century, investors in certain markets were wiped out due to geopolitical upheavals, debt crises, or bursting of bubbles while other countries remained resilient.
- Look beyond Global Markets’ correlations, which don’t capture magnitude of returns.
- Today, Emerging Asia, where U.S. companies often don’t have access to, is led by Korean, Taiwanese or Chinese Tech Companies.
- As a European, follow Buffett’s and Bogle’s Investing Principles rather than their advice to fellow US citizens.
Here is the full analysis
#1 BENEFIT FROM THE NEXT LEAP
Let’s start with one of the biggest misconceptions today – the U.S. Outperformance. Over the past 50 years, the U.S. Market has outperformed the rest of the world by a whooping margin of 1% per year.
The S&P 500 returned on average 9.8% vs. 8.7% for International Markets (ex-US). Even more impressive is the fact that the Index outperformed with lower volatility of 15.2% vs. 17% for International Markets.
A win-win? Well, not quite. Guess, how much of the 50-year outperformance came in the last 8 years? All of it. History doesn’t crawl. It leaps.
Until 2014, the average annual performance was nearly 9.6%, for both Markets. If history is a guide, it is a matter of when, not if, International Stock will catch up again.
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#2 DILUTE HYPE
By investing globally, nearly a third is allocated to the ‘old Economy’. Yes, by many growth measures, Europe and Japan lag. Their heavyweights mainly include Financial or Industrial companies.
Value investing is not very glamorous. But the entry point is cheap. Remember that you can either have high prices or high future returns, not both. The price you pay matters.
The CAPE ratio is just one measure of Stock Markets’ relative attractiveness.
THE PRICE YOU PAY TODAY (CAPE RATIOS)
In Dec’21, the CAPE for the US Market stood at 39 (currently 32, as per the map), an expensive level by historical standards. For the UK, it stood at a modest 17.5. Over the next 8 months, the S&P 500 lost over 20% while the FTSE 100 remained roughly flat. Some market participants, including Vanguard, saw it coming.
CAPE has its flaws. For example, valuations can’t be relied upon in the short term. But investing globally often means lowering the purchase price by diluting currently overhyped sectors or countries.
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Who Are Coaching Sessions For?
- Beginners often ask us: How do I reach my goals? When should I invest? How do I come up with the right asset allocation? What About Short-Term Investing?
- Advanced investors come to us to get their portfolios challenged: What could derail my strategy? Bond Ladder or Bond ETFs? What are risks related to Factor Premia? How much can I withdraw from my portfolio annually?
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#3 INCREASE THE LIKELIHOOD OF FINANCING YOUR GOALS
Annual Volatility For Global Portfolio and Select Markets
By avoiding hype, you may sleep tight. But there is also another, very practical reason, why you may be more confident of reaching your objectives by investing globally. Over the past 50 years, holding a global portfolio also reduced volatility compared to the S&P 500.
Make no mistake, other countries fared far worse than the US. If you limited your portfolio to European or certain Asian Markets, volatilities were from 15% (Switzerland) to 100% (Hong Kong) greater than the global index, according to Vanguard.
But diversifying globally reduces the uncertainty of financing your investment goals, especially if they are medium-term.
#4 Hedge against the risk of being wiped out
Global investing also reduces an even more important risk. The risk of permanently losing your capital.
In the past century, there have been many times when investors saw their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets in other countries remained resilient.
Individual Markets may experience catastrophic losses
There are reasons why the U.S. Stocks increased their relative share from 25% of the Global Stock Market in 1990 to 60% in 2020.
U.S. Corporations are incredible growth engines, powered by technological edge, global exposure, pragmatical thinking and strong governance. The rule of law, solid institutions and the US Dollar make America a unique place to invest.
Performance measured as share of Global Stock Market
Yet today’s America is like a comet. Its nucleus is more powerful than ever. But the dust tail has a hard time following and becomes more visible.
After having cycled Asia and crossed the Pacific, I came to realize that the main challenges the U.S. faces are not external, but internal. Here are just a few that strike cyclists on the West Coast:
- Parts of America are left behind like the comet’s dust. An impossible catch-up game as inequalities are growing.
- Internal conflicts are rising. Whether measured by protests or political drifts.
- Healthcare is inefficient. Lack of social safety net makes scandals that kill hundreds of thousands of people and leave millions addicted, possible.
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#5 LOOK BEYOND HIGH CORRELATIONS
Today, it doesn’t matter where a stock trades, but where it makes money. As an extreme case, the pharmaceutical firm GlaxoSmithKline in UK’s FTSE 100 Index, has almost no revenue exposure to UK consumers.
But if there was a global market sell-off, wouldn’t the same shocks affect both S&P 500 and FTSE 100 companies that are exposed to global demand?
The popular argument goes – why wouldn’t you keep it simple and only invest in the S&P 500, since correlations with other markets are high?
Today, All Stocks are exposed to Global Shocks
| INDEX | % Sales Inside Home Country | % Sales Outside Home Country |
|---|---|---|
| S&P 500 | 62% | 38% |
| FTSE 100 | 22% | 78% |
| CAC 40 | 18% | 83% |
| DAX | 19% | 81% |
| ASX 200 | 58% | 42% |
Indeed, given globalisation, correlations between all markets only keep rising.
But the key aspect to understand is that correlation has its limitations.
Diversification is much more:
- It is also about the magnitude of price moves. Let’s take two Stocks A and B. If A rises 1% when B rises 5%, and A drops 0.3% when the B declines 1.5%, the correlation will be high. In the real world, European or Japanese companies are small-cap value stocks, that may not react to the same degree to shocks, depending on the nature of the crisis, as US Tech, even though the correlation is very high.
- It is about companies that have different exposure to Equity Risk Factors, and that is more important than where they are located.
#6 Bet on EmerGing Asia
There are at least two reasons why with Emerging Markets, you may want to have skin in the game.
First, while the downside is limited, your upside may be asymmetric.
Did you know that today, Chinese Stocks have almost no impact on the performance of a Global Equity ETF? In fact, their entire allocation weighs less than that of Microsoft. Combined, Emerging Markets Stocks only represent c. 10% of a Global ETF.
That’s because of various screens applied by Index providers, due to market segments being difficult to access. Without them, EMs should stand at 26%. Yet, today, six out of ten people live in EMs. They account for over 50% of global GDP. By 2025 they may capture 70% of global growth. Partly through Tech.
While cycling in Asia, I noticed that US Tech companies have little to no access to certain markets. And some super apps like Tencent’s Wechat or Line are much more powerful than Western apps.
Emerging Markets Are Becoming Tech Heavy
Most investors know how Tech dominates the S&P 500. What’s less known, is that Asian Tech is rising to the same proportion of EM Indices.
- IT and Communication firms including Samsung, Taiwan Semiconductors, Tencent or Indian Infosys account for over 30% of EM’s Market Cap.
- By adding E-commerce platforms, like Alibaba or JD.com, that make up most of Consumer Discretionary sector investors capture 46% of EM Equities.
#7 DARE TO DISAGREE WITH BUFFETT AND BOGLE
Upon his passing, Warren Buffett directed the trustee for his wife’s benefit to “put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.” Jack Bogle even went a step further and favoured a fund tracking a larger US Equity Index – the Total Stock Market Fund.
Don't look for the needle in the haystack. Buy The Haystack.
If you follow Buffett and Bogle’s advice, chances are you will end up wealthy. Why? Because the behavioural aspects, low fees, and broad-enough diversification, that both preach will determine most of your success.
They are more important than the S&P 500 vs. World Index debate.
But since you are reading this website, chances are you have an above-average investing acumen. You can use academic research that expands on Buffett & Bogle’s diversification principle and take it a step further.
Don’t try to pick the winning country. Buy them all.
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NEXT STEPS
You may nevertheless decide to increase the allocation to the U.S. Market because you think current trends will continue for a while. But how to implement such tilt tax-efficiently? Let’s have a look at this in the next part of this guide, covering the cheapest S&P 500 trackers with synthetic replication strategy.
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