We are frequently asked about our allocation to Developed International stocks and Emerging Markets stocks.

For several years, we have generally targeted around the non-US equity exposure to 20-25 percent of the equity allocation. 

A pure indexer would argue that we should invest according to the world’s total market capitalization, which would be close to 60 percent of the equity allocation.  So, clearly, we are heavy in the U.S from that perspective.

We believe it is appropriate to overweight the U.S. compared to the pure index view since the future liabilities that our clients face are priced in U.S. dollars and, in general, it makes sense to have a ‘home bias’ that mostly (but not completely) matches the future assets and liabilities in the same currency.

Currently, many investors like PIMCO’s Mohamed El Erian and Goldman Sach’s Jim O’Neill argue that investors should take a more aggressive stance than we are, but a less aggressive stance than the pure indexer and recommend something between 30 and 40 percent.

Historically, International Developed stocks have not enjoyed as strong as performance as large-cap stocks and they have experienced more volatility.  In the 40 years of MSCI EAFE data, the annual return was 7.79 percent compared to 9.86 percent for the S&P 500.  Volatility for the MSCI EAFE was 22.71 percent, compared to 18.13 percent.  Combining these two factors using the Sharpe Ratio, demonstrates that for the last 40 years, the S&P 500 has been a much better investment (0.23 S&P 500 Sharpe vs. 0.09 for EAFE).

There is still merit in holding EAFE, however, as part of a diversified portfolio since the correlation between the S&P 500 and MSCI EAFE was 0.65 for the 40 year period.  However, the correlation has increased considerably in recent years, which is a factor that we watch closely.

Looking forward, it is hard to envision that Developed Markets will be much stronger than U.S. markets.  Japan is demographic basket case and Great Britain and Continental Europe are struggling under the weight of their entitlement programs, structurally high unemployment and low growth.

So, with EAFE only somewhat appealing, more investors are looking to Emerging Markets (EME).  Some of this is undoubtedly performance chasing, as EME has gone up 11.78 percent per annum over the last decade while the S&P 500 has been -0.43 percent (9/30/00 – 09/30/10).  They have done well coming out of the Great Recession and growth expectations are high.

Our concern is that investors are overweighting solely on the basis of expected economic growth.  A recent study by Vanguard demonstrated that there is a relatively weak long-run relationship between GDP and stock returns over long periods of time.  Still, the valuation for EME stocks is comparable to the U.S., even though the expected growth rates are much higher, making a compelling argument. 

We are slightly overweight EME relative to Developed in the sense that 23 percent of our non-U.S. equity allocation is dedicated to emerging, compared with the pure indexer view that would allocate 19 percent to Emerging.  We are hesitant to go much further on the basis that EME is very volatile.  The data for EME only reliably goes back to 1988 and since that time, the volatility as measured by the standard deviation nearly double that of the S&P 500. 

Looking back at the admittedly limited data, we see that EME stocks have gained 11.83 percent since 1988 with a standard deviation of 36.84 percent.  The S&P 500 has returned less: 9.55 percent over the same time frame, but the volatility has been much less: 19.35 percent.  Combining these metrics with the Sharpe ratio, we see that the historic risk-adjusted returns have been more attractive for the S&P 500 (Sharpe 0.28) versus the EME (Sharpe 0.21). 

On this basis, we are comfortable with our somewhat modest allocation to Developed Market and Emerging Markets stocks.