Benchmarks play an important role in investment management for many reasons including: 1) they serve as the default position for portfolio allocation, 2) they provide investment managers with a target to shoot for (and hopefully exceed), and 3) they provide the basis for comparison when evaluating performance as well as risk, which often overlooked but an important role in benchmarking.
Money managers often say that they look for the best “risk adjusted returns”, but then fail to identify how they calculate risk. At the end of the year, most investors can look back at their performance and compare it to various measures, such as where they started the year or how the S&P 500 or bond markets fared to determine if they had a good year, a mediocre year, or a bad year, but these same investors rarely reflect on the amount of risk they took to achieve their performance.
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The Wisdom of Changing Benchmarks?
Many institutional investors use a passive benchmark of a 70% allocation to the MSCI All World Index and 30% weighting in the Bloomberg Barclays Aggregate Index, the 70/30 portfolio, as the basis for comparing their performance. This hasn’t always been the case. As global equity markets developed over the past decades, there has been a migration away from what was the traditional balanced portfolio benchmark which called for 60% weighting in U.S. Stocks, the S&P 500, and 40% in bonds, the Bloomberg Barclays Aggregate (previously known as the Lehman Aggregate Index) to the 70/30 mix. At first glance, one may think that these two are broadly similar, especially as they both use the same bond index, but when you look at the constituents of the equity component, the difference becomes apparent. As the name suggests, the MSCI All World Index is a global benchmark with a weighting of about 65% in the U.S., 30% in developed foreign markets, and 10% in emerging markets, which translates into the weightings (rounded) below, showing the dramatic increased exposure to international stock going from zero to about 25%.
Composition difference between the 60/40 and the 70/30 portfolios
What Prompted some Institutions to Change?
Over the past thirty years, a number of things happened to bolster the case for looking outside the U.S. for investment opportunities. In the eighties, the Japanese stock market soared, the nineties saw the formation of the European Union and the launch of the Euro, followed by many stock listings of previously state controlled companies, later on there was the BRICs trade as emerging markets, Brazil, Russia, India and China came into focus. Technology made cross border trading far easier.
The basic logic for international investing is understandable, the United States does not have a monopoly on great companies, so why constrain one’s investment opportunity set solely to the U.S.? It makes perfect sense that investors scour the globe in search of value, and institutional investors wanted the freedom to invest outside of the U.S., so many broadened their mandates to include international and emerging markets, and switched from the 60/40 to the 70/30 benchmark.
So What Happened?
Unfortunately for institutions that adopted the 70/30 mix, performance trailed the 60/40 blend by about a half a percent a year over the 20 year period to September 2021, or cumulatively close to 10%. The underperformance of the 70/30 was more pronounced in the past 10 years, at over 1.5% per year.
So What Happened?
There is a very simple reason that the 60/40 beat the 70/30, the U.S stock market as measured by the S&P 500 outperformed the MSCI All Word Index. The Before we look at the difference in performance between the two indices, it is worth mentioning that there are only two reasons to adjust investment positions, 1) for a higher expected return, or 2) to reduce risk. The higher expected return is self explanatory, but a discussion on risk is a more complex subject. Money managers are particularly a savvy group. They knew they needed a new benchmark, but more importantly they knew they needed a reason to switch to the new benchmark. The easy answer – higher returns. The basic argument is that adding international stocks would lower volatility as some foreign markets would go up when the U.S. was down, and vice versa. Lower volatility in your equity book means you can increase your exposure to higher returning stocks and lower your allocation to low yielding bonds, while keeping your overall volatility level (or risk) about the same. And so the 70/30 benchmark which shifted 10% out of bonds (from 40% to 30%) and into stocks came into vogue with the 70% stock portfolio pegged at matching a global index, not just the U.S.
It bears noting that by increasing the equity exposure from 60% to 70%, institutional managers expected higher returns at a comparable volatility level.
Money managers are particularly a savvy group. They knew they needed a new benchmark, but more importantly they knew they needed a reason to switch to the new benchmark. The easy answer – higher returns. The basic argument is that adding international stocks would lower volatility as some foreign markets would go up when the U.S. was down, and vice versa. Lower volatility in your equity book means you can increase your exposure to higher returning stocks and lower your allocation to low yielding bonds, while keeping your overall volatility level (or risk) about the same. And so the 70/30 benchmark which shifted 10% out of bonds (from 40% to 30%) and into stocks came into vogue with the 70% stock portfolio pegged at matching a global index, not just the U.S.
Money managers are particularly a savvy group. They realized that if they were going to look outside the U.S. for stocks, they wanted to be judged against a broader gauge than the U.S. based S&P 500, so many institutional investors switched their equity benchmark to the MSCI All World Index, which is about 50% U.S. based, 35% Developed Markets (U.K., Europe, Japan for example) and 15% Emerging Markets. Furthermore, these institutional investors figured that by diversifying away from only U.S. stocks, they could increase their equity exposure and maintain a similar risk/volatility level. These assumptions led institutional investors to adopt the 70/30 benchmark comprised of 70% MSCI All World Index an 30% Bloomberg Barclays U.S. Bond Aggregate as shown in the chart above.
An Introduction to Volatility as Risk
Institutional investors were happy to accept the 70/30 mix because for the higher expected return (after all they were dialing up their equity exposure and reducing their allocation to high grade bonds), and were willing to believe that the new benchmark had a similar risk profiles.
But step away from the math for a minute. If someone sat down at your kitchen table and said that they were going to sell 10% your bond portfolio and replace that 10% with emerging market equities, and somehow maintain the same level of risk/volatility, by adding some other developed market stocks, you might question this alchemy.
So How has it Worked Out?
An easily and often looked over element of international investing is foreign currency exposure. If, for example, you wanted to buy local shares in a Swiss company, step one is to buy Swiss Francs and then step two is to buy the shares. Where did you get the money for the Francs? You sold/exchange dollars for Francs. When you want to exit the position, you reverse the process, sell your shares for Swiss Francs and exchange/buy dollars. The investment term for selling something and buying it back later is “shorting”. There is nothing insidious about “shorting” the dollar, it’s just a mechanical process you need to go through to buy international stocks. Of course you can hedge your currency exposure with futures and options, but they tend to get expensive, especially long term hedges, so most long term international investors accept currency fluctuations as part of their overall investment process.
So if one wanted to mimic the performance of a 70/30 mix versus a 60/40 portfolio, it implies about a 40% (Developed and Emerging Markets combined weight) bet against the U.S. Dollar.
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The graph below is the 10 year historical exchange rate of the Euro and the US Dollar. As you can see in the first 4 years through 2012, the value of a Euro hovered around $1.30 – $1.40 for the most part, the relationship remained fairly stable until 2013 when the Euro came under pressure as a result of the Greek debt crisis and other factors. While this was good news for US travelers to Europe, it was bad news for US investors holding European assets. If you held shares worth 1 million Euros at the end of 2013 and the share price stayed exactly the same through 2016, you would have lost $320,000 or 24%. As we noted above, many foundations had significant international exposure.
Understand Your Bets
IA reader may conclude that Foundation Advocate doesn’t believe in international equities, nothing could be further from the truth. The point of this article is to understand your bets, learn from your mistakes (or hopefully other people’s mistakes), and hopefully be better prepared for tomorrow’s investment opportunities and challenges.