Historically, U.S. investors have sought out international equities for a number of reasons. Over extended periods of time this asset class has outperformed U.S. equities, it has provided diversification benefits, and some have used international stock exposure to address offshore business interests and currency management concerns.
However, the advantages of diversification have diminished because of rising correlations among developed markets. Furthermore, as the U.S. equity market enjoyed substantial success in the last decade relative to other markets, it has been more difficult to make the case to go beyond the United States in search of higher returns.
Yet international equities remain an essential asset class for U.S. plan sponsors. The key is to find international investment solutions that offer the prospect of generating strong risk-adjusted returns on a consistent basis that might even be competitive with U.S. equity returns.
Our search for these solutions has led to the following conclusions:
* Plan sponsors should maintain their international equity allocations for return enhancement and risk diversification.
* Active managers have been able to achieve above-benchmark returns relative to a "soft" international equity benchmark, often by "getting Japan right," but have not generated attractive absolute returns, particularly relative to U.S. equity performance over the past 10 years.
* Emerging market and international small-cap equities can be considered as alternatives to a traditional international large-cap equity strategy. However, these strategies introduce specific asset class risks that can substantially alter the risk profile of the portfolio.
* International large-cap equity specialist options exist that can enhance the risk/return profile of an investor's international equity allocation.
Before elaborating on these conclusions, we should define the proxies used for the various asset classes under review. The Standard & Poor's 500 index represents U.S. equities; the Morgan Stanley Capital International Europe Australasia Far East index is a proxy for large-cap equity investing outside the United States; the MSCI Emerging Markets Free index represents emerging market equities; and the Salomon Brothers World (ex-U.S.) Extended Market index is used for international small-cap securities.
Disappointing track record
Sponsors certainly have been disappointed with the relative performance of international equities. For the 10-year period ended Dec. 31, 2000, the MSCI EAFE returned a compound annual 8.6% in U.S. dollar terms - less than half the 17.5% annual return of the S&P 500 in the same period. In addition, U.S. equities experienced less volatility, measured in terms of standard deviation. The Sharpe Ratio, which measures reward per unit of risk and is calculated by dividing the return in excess of the risk free rate by the standard deviation, was 0.94 for the S&P 500 and 0.25 for EAFE.
Moreover, the argument for diversification has been weakened by the rising correlation between EAFE and the S&P 500, from 0.47 in December 1991 to 0.65 in September 2001. The growing influence of multinational corporations on international investing also has hurt the case for diversification. Arguably, country of domicile is less critical for multinationals such as Nokia, Ericsson and Motorola than the global market environment for telecommunications or the trading activity of U.S. markets, on which all three are listed.
However, historical data show a mix of EAFE and the S&P can offer competitive returns with less risk than an all-U.S. portfolio. Over the past 10 years, a portfolio comprising 80% S&P and 20% EAFE demonstrated a standard deviation of 12.7% vs. 13.4% for the S&P 500. During the same period, the composite portfolio returned 15.8% compared with 17.5% for the S&P 500. The Sharpe Ratios for the composite portfolio and the S&P 500 were 0.86 and 0.94, respectively.
How then can the performance of this asset class be improved? A good starting point is an examination of the asset class itself, or the investment approach that may form the basis of an alternative strategy.
It is critical to distinguish between alternative international asset classes inside EAFE and those outside of it. Two frequently mentioned alternatives are emerging market and international small-cap equities. Investment mandates focusing on these two fall largely outside of an EAFE mandate and typically are measured relative to a distinct benchmark focusing on either emerging market or international small-cap equities.
Looking at emerging markets
Emerging market equities have two clear advantages: high potential returns, and low correlations with EAFE. Over the 10 years ended Dec. 31, 2000, emerging market stocks generated compound annual returns of 8.3% compared with 8.6% for EAFE. While emerging market equities can offer tremendous returns, timing is critical. Emerging market equities returned 65% in 1989, 60% in 1991, 75% in 1993 and 66% in 1999, but suffered wrenching declines in 1998 (-25%) and 2000 (-31%).
For investors that can handle the volatility of returns, emerging market equities also offer the advantage of low correlations with both EAFE and U.S. equities. Although correlations have increased, U.S. equities are less correlated to emerging market equities than to EAFE.
However, emerging market equities have several drawbacks:
* High volatility. Their standard deviations have been consistently higher than those of either EAFE or U.S. equities. Historical standard deviations for the MSCI EMF have averaged 23% in the past 10 years, compared with 14% for EAFE.
* Political risk. Despite advances in risk analysis, sudden shifts in the political climate of developing countries can be impossible to forecast. For example, the decision by Russia to default on its debt in August 1998 was totally unexpected.
* Currency risk. Emerging market currencies can be extremely volatile and often illiquid in times of crisis. In 1993, a local currency gain of 138% in the MSCI EMF was more than halved by exchange movements, to 65% in U.S. dollar terms.
* Liquidity risk. This ranges from unilateral moves to restrict market freedom - such as Malaysia's decision in September 1998 to ban repatriation of foreign investor proceeds - to indigenous market practices, including limited trading hours, high trading costs and a small number of listed companies.
What about small caps?
International small-cap stocks do not have the inherent volatility of emerging market equities. In the decade ended Dec. 31, 2000, international small-cap standard deviations averaged 15% vs. the 23% we saw for emerging market equities. In fact, small-cap volatility closely tracked EAFE volatility over this period.
This risk profile is not surprising, given that correlations between the Salomon World ex-U.S. EMI and EAFE have exceeded 90% over the past 10 years. At the same time, international small caps exhibit lower correlations with U.S. equities than with EAFE.
The developed-market orientation of international small caps offers several advantages relative to emerging market equities, including reduced political, currency and transparency risk. On the other hand, small caps have some clear disadvantages, notably:
* Lagging performance. Over the ten years ended Dec. 31, 2000, international small caps have trailed EAFE by 3.6 percentage points, 5.0% to 8.6%.
* High correlations with EAFE.
* Market-cap risk. Market capitalization preferences can change rapidly and are difficult to predict. For example, in the latter half of the 1990s U.S. small-caps underperformed large caps by wide margins over a prolonged period.
* Transparency risk. Accounting standards, even in developed countries, may not guarantee sufficient information for rigorous analysis of small-cap securities. Extensive local knowledge may be necessary to develop a robust investment opinion on a small-cap security, and this can be expensive and time consuming.
* Liquidity risk. Poor liquidity and high trading costs can negatively affect investing in small-cap issues.
In summary, both emerging market and international small-cap mandates introduce asset-class or market-cap risks not typically present in a traditional EAFE allocation.
There are several ways to add value to an EAFE allocation without introducing asset class or market cap risks. Popular strategies seeking to exploit excess return opportunities within EAFE often look to capitalize on country, currency or style preferences, while others focus on sector rotation or security selection. Common to most of these is some top-down orientation, and while this approach has the greatest potential for return, its risk potential is equally great.
Clearly, individual country returns, currency movements, sector biases and style tilts can affect portfolio returns. The increasing availability of international derivative vehicles permits more efficient investing in countries, currencies or industries than in the past. However, top-down investing has some negative aspects:
* Investibility. Managers may sacrifice investibility in some good ideas because of the limitations of using derivative instruments to gain exposure to investment opportunities. Top-down strategies may be inefficient tools for unlocking more focused investment themes.
* Market timing. Adroit timing is the key differentiator between success and failure in any rotational strategy. Large rotational bets can backfire disastrously, as evidenced by the currency markets during the Mexican peso crisis of 1994, the Asian crisis of 1997 and the Russian debt default of 1998.
* Repeatability. The ability of any rotation-based strategy to repeat itself is highly questionable. The successful anticipation of large market moves is a difficult process to repeat over the investment time horizon of almost any plan.
* Risk control. Rotational strategies do not easily lend themselves to effective risk control, which ultimately is predicated on some degree of forecastability as well as the availability of effective hedging tools. These are often both in short supply in top-down strategies.
Stock selection is critical
Stock selection now has become at least as important as country and sector allocations. A specialized EAFE satellite strategy focusing exclusively on the generation of alpha at the individual security level can be very effective in complementing an existing core strategy.
The key is to concentrate on securities offering the prospect of above-market returns based on an examination of fundamental business strengths, competitive industry position, expected earnings growth and current valuations. While countries and currencies arguably have become less important, macro-economic factors can still be incorporated into most bottom-up strategies.
We evaluated a group of international equity managers that use investment processes based predominantly on individual security selection to see how effective this particular approach could be. We selected these managers using Investworks, screening for separate account managers benchmarked against EAFE that classify themselves as "stock pickers" with five- or 10-year performance histories. We then used Mobius and Plan Sponsor Network to obtain the return series of the managers in our survey sample. We compared these approaches to EAFE, EMF and SBEMI World ex-U.S. as well as an optimized composite portfolio blending these three indexes over the five- and 10-year periods ended Dec. 31, 2000. The optimized composite portfolio serves as a proxy for an ideal top-down portfolio.
Our study showed two important benefits of a bottom-up approach.
First, expected returns due to stock selection were greater than the expected return associated with the composite portfolio over both five- and 10-year horizons. In some cases, the returns posted by bottom-up managers were competitive with historic rates of return in U.S. markets.
Second, portfolio risk associated with some of the bottom-up managers was competitive with the composite portfolio over both periods. During the five-year period, the risk inherent in some of these strategies even fell within the range of standard deviations seen in U.S. markets (Table 1). The increase in return and risk reduction resulted in a more optimal positioning of bottom-up managers on the efficient frontier over both periods (see Figures 1 and 2).
Sponsors also may benefit from bottom-up strategies for other reasons, particularly in the context of a core/satellite structure. These strategies typically offer greater investibility and more transparency than derivative-based approaches.
Eleanor Marsh is vice president and international equity portfolio manager at State Street Research & Management Co., Boston.