When we talk about evidence-based investing, we often mention the importance of going global.
Global diversification ensures that you aren’t placing all of your financial faith in the fate of any one country’s concentrated risks. It also helps you combat your natural tendency to bulk up on investments closer to home, where you imagine you’ll be safer or better off over the long haul.
That’s known in behavioral finance as “familiarity” or “home-town” bias, and it’s premised on false assumptions. We’re as patriotic as the next Americans. But the evidence still informs us that human commerce knows few borders, so neither should our investments.
That’s the long view on global diversification. But have you ever wondered about some of the details?
Say, for example, you were to invest half of your portfolio in a U.S. equity index fund, and the other half in an international index fund, “ex-U.S.” In terms of number of stocks as well as market cap (the total dollar value of a public company’s outstanding shares), how diversified are you, really? Are you still at a 50/50 split?
Dimensional Fund Advisors recently published “Going Global: A Look at Public Company Listings,” to explore some of these underlying questions. Some of its findings:
- Worldwide, there are more publicly traded stocks than their used to be, increasing from about 23,000 to 33,000 between 1995 and year-end 2016.
- In the U.S., there are fewer publicly traded stocks than their used to be. Using the Wilshire 5000 Total Market Index as a benchmark, U.S. stocks declined from about 5,000 to 3,600 companies between 2005 and year-end 2016. (That’s right, the “Wilshire 5000” actually only tracks about 3,600 stocks these days.)
- As measured by market cap, the U.S. still dominates global markets – by far, at 54% of the world’s market cap. That’s also an increase from 40% in 1995. The next biggest contender? Japan at 8%. (See our accompanying “Illustration of the Month.”)
- Many index funds only expose their shareholders to a fraction of these total available stocks. From Dimensional’s report: “For example, one well-known global benchmark, the MSCI All Country World Index Investable Market Index (MSCI ACWI IMI) contains between 8,000 and 9,000 stocks. … For comparison, the Dimensional investable universe, at around 13,000 stocks, is broader.”
What can you draw from these insights besides trivia to share at your next social gathering? Zooming back to our favorite vantage point – the Long View – there are still plenty of opportunities in plenty of places to maintain your efficient, effective, globally diversified investment strategy.
Part of our job here at Hill Investment Group is to keep a relatively close eye on financial industry news, so our clients don’t have to (unless they find it interesting). One technical tidbit caught our eye recently when Vanguard’s advisor news channel reported on how its index funds will be impacted by a change to the way the Center for Research in Security Prices (CRSP) will be reconstituting its indexes.
Wow, that’s a lot of jargon. Let’s translate.
Most investors are familiar with the broad strokes of index investing. An index fund identifies a slice of the market to invest in – such as U.S. small-company value stocks. The fund manager then picks an index that tracks that same swath, and buys up essentially everything that index is holding. For the past several years, Vanguard has been using CRSP indexes to fulfill that role.
Mostly, that’s a relatively sensible way to go about investing. CRSP indexes are at least as robust as any others for tracking particular markets. And index funds are certainly better than active managers, who spend their time and your money trying to dodge in and out of markets, without adding expected extra worth.
If there weren’t an even better – let’s say best – way to go about it, we’d probably be all in on index funds ourselves (and there are times we use them, when we feel they are the ideal tool for the job at hand). But, instead of investing in funds that follow indexes that follow a swath of the market … we typically prefer funds that skip the index “middle man,” and buy into the vast majority of a market swath directly. Dimensional Fund Advisors is one such fund manager, and the longest-tenured among them, having been around since 1981.
Vanguard’s recent announcement speaks to one reason we prefer the more direct approach. One bugaboo index funds face is what to do whenever its underlying index “reconstitutes,” or changes the securities it’s tracking. Every index does this from time to time. For example, say a small company becomes a big company. A small-cap index must then stop tracking its stock and, usually, pick a different one to track instead.
That means any index fund tracking that index must actually sell and buy those same swapped-out securities – and relatively quickly if it wants to keep accurately reflecting its target index. You may already be a step ahead of me if you recognize that this creates some pricing challenges. If several index fund managers are all trying to sell and buy the same securities at around the same time, the trades can end up costing more than if there weren’t an essentially artificial supply-and-demand issue at play.
To help alleviate (although probably not eliminate) that challenge, CRSP has announced it will spread its reconstitution activities across five days instead of just one.
Again, that’s a sensible idea, and it may help some. But remember, fund managers like Dimensional allow us to avoid the reconstitution challenge entirely by more directly tracking the small-cap value market (and many others). This is a topic for another post, but direct tracking also offers other advantages over being tied to an index. Suffice it to say here that not all small-cap value funds are equally as effective at capturing the expected premiums available from this relatively narrow market.
So, with respect to Vanguard’s recent announcement, “better” is nice. But when the choice is, “better or best?” … we still prefer best.
Even though we at Hill Investment Group do our best to always Take the Long View, I have a confession to make: When it comes to investment performance, I still have days and even years that I like more than others. 2016 is one of them.
It’s not just because the annual performance numbers across many of our global markets were remarkably strong. That’s nice, but I’m more interested in the tale these numbers tell us – or, actually, re-tell us – about investing in good times and bad.
Asset allocation (still) makes sense.
After a few years of underdog performance that tested many investors’ discipline, small-cap and value stocks proved their mettle this year, globally and especially in the U.S. As Dimensional Fund Advisors observed in its recently released 2016 Market Review (emphasis ours): “Over 2016, the US small cap premium marked the seventh highest annual return difference since 1979 when measured by the Russell 2000 Index minus Russell 1000 Index.”
Market-timing (still) does NOT make sense.
2016 also was a text-book example of how investors who may have been tempted to try to capture the market’s crests and avoid its chasms would likely have missed out on the year’s ultimately rewarding returns. To share Wes Wellington’s comments from his “Look Back at 2016“:
“Every year brings its share of surprises. But how many of us could have imagined that 2016 would see the Chicago Cubs win the World Series, Bob Dylan receive the Nobel Prize in Literature, Donald Trump elected president, and the Dow Jones Industrial Average close out the year a whisker away from 20,000? The answer is very few—a lesson that investors would be wise to remember.”
Dimensional’s report further notes (emphasis ours): “Most of the performance for small caps came in the last two months of the year, after the US election on November 8.” This represents another outcome that would have been difficult if not impossible to predict without a great deal of luck on your side.
Diversification remains your best bet.
Almost two years ago to the day, following a year in which U.S. large-cap stocks had continued to outperform most other asset classes, I posted this reminder about the importance of remaining diversified: “Clearly, the tables can turn abruptly and destructively for the nondiversified investor.”
With small-cap and value stocks’ strong resurgence, 2016 reemphasized this same lesson in a fresh way. It tells us that diversification remains as important as ever in a world in which near-term prognostications remain a matter of luck, not skill.
As Oaktree Capital’s Howard Marks expressed in his “opinion of opinions” in a recent post:
“There are no facts about the future, just opinions. Anyone who asserts with conviction what he thinks will happen in the macro future is overstating his foresight, whether out of ignorance, hubris or dishonesty.”
What does 2017 have in store for us as investors? In all honesty, I don’t have the hubris to guess.