Laying a global foundation for equity allocations

Cobbling together individual strategies across regions and styles in a piecemeal approach often leaves equity investors with a home country bias and incomplete coverage of global markets. We suggest fixing this potential problem by using active global equity as the core of the portfolio allocation.

In building portfolios, most allocators segment their equity exposures by geographic region, country or style factor. Often, they begin with a “core” regional holding and add other portfolio components to achieve balance vs. the global opportunity set, gaining exposure to the breadth of the equity market with a mix of individually tailored active or passive strategies.

This “divide and conquer” approach offers an advantage—namely a high level of visibility into, and control over, the distribution of risk—but it comes with some potential disadvantages that tend to manifest over time:

  • Using a regional or home country benchmark as the core holding, instead of starting from the broadest global foundation, imparts an inefficient bias to equity allocations.
  •  Deploying active management only within these narrowly defined opportunity sets (or avoiding it altogether by using passive strategies) may constrain any potential added value.
  • Using multiple narrow benchmarks can limit flexibility and reduce access to the most valuable opportunities that emerge over time and across the boundaries of various portfolio sleeves.

There is a practical approach that addresses the shortcomings of this “distributed” model of equity allocation. Investors should consider shifting a meaningful portion of their equity to an active manager, operating against a broad global benchmark, as a “core” holding. This ensures that portion of their capital is free to find the best opportunities wherever they reside—regardless of geography, style or passive bias—and in the process capture an element of additional performance missing from the industry’s more traditional, segmented approach (Exhibit 1).

The value of the global opportunity set

In the U.S., “home country” bias is common in equity portfolios; this approach often reflects habit rather than purely rational portfolio optimization. Strategic asset allocations frequently contain a minimum weight to U.S. equity and a maximum weight to non-U.S. equity, without much regard to their relative valuations or expected returns.

Exhibit 2 illustrates the potential future costs of structurally underweighting global equity, using J.P. Morgan Asset Management’s 2024 Long-Term Capital Market Assumptions, which forecasts asset class returns over a 10- to 15-year horizon. These returns are beta-only and do not reflect any potential benefit from active management. Non-U.S. developed market equities exhibit materially higher return assumptions than U.S. equities, driven by improving fundamentals and lower current valuations, as well as the anticipation of local currency appreciation relative to the U.S. dollar.

From a bottom-up perspective, the case for global equity also looks positive. Exhibit 3 shows the 50 best-performing stocks in the MSCI All-Country World Index (ACWI) by calendar year from 2002 to 2021. In most years there are more top-performing stocks in non-U.S. markets.

The beta argument: Global equity as a portfolio foundation

Investors have begun to consider using a global equity strategy as a core holding, and potentially as the foundation of their entire equity allocation. Rather than starting with a home-country or regional bias, a global equity strategy benchmarked to the MSCI ACWI captures the full opportunity set. Should the expected returns shift over time in favor of different geographic regions, investors can be confident that they will not miss out entirely.

Further, having established the “anchor” of this global core allocation, subsequent portfolio tilts can be implemented via more narrowly focused strategies. Investors can tailor their overall market exposure to their research and investment preferences by allocating to specific regions or styles. Exhibit 4 illustrates different frameworks for introducing global equity within an equity allocation, starting as a modest addition to the non-U.S. sectors and ultimately serving as the foundation for the entire equity strategy.

The alpha argument: Global equity as a core holding

An active global equity strategy can be tailored to any specific use case, but managers need to have a few essential attributes given the breadth and complexity of the global equity market. In our view, the most critical skills include strong quantitative analytics that allow efficient evaluation of the full opportunity set, a deep global fundamental research team with “boots on the ground” in major markets and a proven investment process that has navigated multiple market cycles.

We have found it useful to classify active global strategies by three categories, based on the degree of portfolio concentration, alpha expectation and tracking error:

  • “Research-enhanced” strategies invest in a broader cross section of the benchmark, targeting highly rated firms across sectors and geographies. These strategies are designed to deliver outperformance with risk that is more closely aligned to the benchmark itself.
  • “Select” strategies, which can tolerate a higher level of tracking error, narrow the focus to sectors and firms with the highest research ratings, seeking a greater level of alpha.
  • “Focus” strategies operate with limited constraints, targeting a narrow group of “best ideas” across the global opportunity set. We would expect alpha and tracking error to be highest in these portfolios (Exhibit 5).

Conclusion: Active global equity as a portfolio’s core anchor

Cobbling together individual strategies across regions and styles in a piecemeal approach often leaves equity investors with a home country bias and incomplete coverage of global markets, which may limit their ability to capture bottom-up and regional opportunities as they arise. We suggest fixing this potential problem by using active global equity as the core of the portfolio allocation. Not only can such a strategy be tailored to fit an investor’s need for beta diversification and alpha generation, but also it can serve as a stable foundation across time for the construction and management of a diverse mix of more targeted strategies.

JPMAM Long Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only–they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice.  The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations.  “Expected” or “Alpha” return estimates are subject to uncertainty and error.  For example changes in the historical data from which it is estimated will result in different implications for asset class returns.  Expected returns for each asset class conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein.  References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve.  Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only—they do not consider the impact of active management.  A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.