The U.S. Equity Market is Special
Ask a CIO #12
Over the past 18 years, I’ve invested in equity markets across the world. On behalf of my prior institutions, I’ve invested in global funds, regional funds, and single country funds. I’ve invested in developed and emerging markets. I’ve invested in long-only and hedged equity funds.
I share this background only to say that I understand the rationale for investing outside the U.S., and I’ve also experienced the risks and tradeoffs.
Of all the ways in which my investment perspective has changed over the years, I think my views on public equity investing have changed the most. So as I tackle this week’s question, I’m also reflective of the fact that my answer today is very different than it would have been 10 years ago.
Most target-date funds have a healthy international equities allocation. How do you view that choice?
If I can zoom out for a second here, I’d like to use your question to discuss the value of international equities for a typical U.S. investor. I’ll address your question specifically as it pertains to target date funds toward the end, but let’s start with a broader look at international equities.
Actually, let’s start by taking a look at U.S. equities. As U.S. based investors, I think we sometimes take for granted the advantages we enjoy in the U.S. equity market.
For starters, the U.S. economy is the largest in the world by GDP, and it is powered by a huge breadth of industries. It is highly developed, highly productive, and highly innovative. The U.S. also has multiple attractive conditions that provide domestic companies with competitive advantages. It’s not perfect, but we have a well-connected and reliable infrastructure and transportation system across the country. We have abundant natural resources. And we have (mostly) established legal and regulatory frameworks that make it possible to (mostly) reliably conduct business, and by extension, understand and forecast the value of those businesses.
The size and diversity of the U.S. economy is reflected in the U.S. equity market, which is both broad and deep.1 The major U.S. equity indices (S&P 500, Russell 2000, etc.) are highly liquid, as are most of the underlying constituents. It’s reasonably difficult, just from a structural standpoint, for any individual to manipulate U.S. equities.2
From a governance standpoint, when we invest in the stock of a U.S. company, we have reasonable confidence that the company and its independent Board of Directors is accountable to shareholders. We are accustomed to both frequent and reliable publicly available information, corporate filings, and earnings data. The SEC, for all the heat it gets from different corners of the capital markets, takes insider trading seriously and upholds a reasonably level playing field for investors.
And finally, as U.S. investors investing in U.S. equities, we don’t have to think twice about the value of the U.S. dollar relative to any other currency. Which is kind of a big deal.3
The U.S. equity market is unique in the world. By virtue of being U.S. equity investors (using the S&P 500 Index as a stand-in here), we are inherently diversified by industry. We are also, given the large number of companies with global operations, diversified by global revenue streams. Investing in U.S. companies actually provides ample international exposure.
The U.S. equity market is also highly efficient. It’s perfectly acceptable, and in many cases preferable, to be a passive investor in U.S. equities.
Now let’s talk about international equities, starting with developed non-U.S. equity markets. When institutional investors discuss developed non-U.S. equities, we typically reference the MSCI EAFE Index (EAFE is short for Europe, Australasia and Far East)4 or regional indices comprised of portions of EAFE constituents.
EAFE is obviously a mix of different countries. These countries have different rules of law, different corporate governance norms, and different market dynamics. Shareholder reporting is conducted in different languages, and the equity markets reflect various local currencies.
In general, the equity markets of the individual countries in EAFE aren’t broad enough to justify dedicated country funds, so most international equity funds are regional funds.5 But the various idiosyncrasies I noted above require investors in each equity market to have some degree of local expertise. This dynamic can result in greater inefficiencies in EAFE markets versus the U.S. equity market. The greater the inefficiencies, the less compelling the market is as a passive index investment.
Now let’s briefly touch on emerging markets equities. Think about all of the dynamics that make EAFE markets harder to invest in than the U.S. market. Now layer in lesser corporate governance standards, reduced shareholder protections, and greater political and regulatory instability. Oh, and the risk of currency destabilization. Emerging markets are not efficient markets. And again, the greater the inefficiencies, the less compelling the market as a passive index investment.
Now for all of the added complexity associated with investing in international equities, this is how you would have been rewarded over the past 20 years.6 All data below from Bloomberg, through July 31, 2024.
I’m going to conclude on a perhaps controversial note (but likely predictable given all I’ve written above). I don’t think the average individual U.S. investor needs to hold international equities. And I think investing in international equities through index funds, which is what target date funds typically do, is an outright bad idea. The U.S. equity market has many inherent advantages – for many individual investors, it’s the only public equity market you need in your portfolio.
As always, if you have a question - or after this week’s note, if you’d like to strongly disagree with me! - please reach out: askacio@ivyinvest.co.
Until next week,
Wendy
It is certainly an issue that U.S. public equities don’t capture the whole of the U.S. economy. Increasingly, a lot of growth, innovation, and value creation is happening in private markets. That said, the U.S. public equity market is still reasonably representative of the broader U.S. economy and holds some of the best, most globally competitive companies in the world.
Yes, it happens periodically in smaller U.S. companies. The GameStop meme stock episodes come to mind. But broadly speaking, these are infrequent occurrences in U.S. markets and virtually unheard of in large cap stocks. Let’s just say it’s less infrequent in international equity markets, particularly emerging markets.
It’s a huge advantage that the U.S. dollar is generally regarded as the international reserve currency and currency of record for international transactions. It’s really hard to overstate how fortunate we are to be, by default, U.S. dollar investors.
The Far East geographic reference is…outdated, and the region is better known today as the Asia Pacific.
Japan is a notable exception, as there are plenty of dedicated Japanese equity funds. That said, investing in Japanese equities has not been particularly easy, and the history there would need a separate writeup.
International equities broadly also have not provided much in terms of diversification benefits during U.S. equity market drawdowns.