Correlations have also risen within non-U.S. equity investment styles and market capitalizations. Exhibit 1 shows correlations of returns for the four main international equity styles — large-cap growth, large-cap value, small-cap growth and small-cap value — for the 15 years ended Dec. 31, 2005. Since the early 1990s, the correlation between non-U.S. large-cap growth and non-U.S. large-cap value stocks has been persistently high, interrupted only by the bubble period of the late 1990s, to reside now at 0.98. In other words, non-U.S. growth and non-U.S. value equity returns have moved in near-perfect cadence for the last 12 months.
The direction in performance of international small-cap growth and value stocks has been similarly in lock step as indicated by the line in the exhibit, with even greater divergence than large-caps during the bubble period. Since then, the direction of returns for non-U.S. small-cap stocks has been almost identical, regardless of style.
At the same time, returns for all active international equity managers have registered unusually strong correlations to the MSCI EAFE benchmark. Our research shows a startling compression of returns among managers relative to the EAFE index in the past three years, leading to the assumption that active non-U.S. equity managers are less willing to take risk in their portfolios. Tracking error among active managers has also compressed to very low levels, lending credence to that notion. However, the range of active international equity manager returns relative to the EAFE index suggests otherwise.
Although recent returns for active international equity managers have moved in near-perfect tandem with the index returns, absolute returns have varied as much as they have in the past. In practice, the universe of investment managers has delivered a wide array of returns, but has produced very little diversification among managers — an important consideration for investors employing a multimanager approach to international equities.