The guided tour: Making the case for active investing in international equity

Veteran investors, like seasoned travelers, understand that when seeking out the most compelling experiences in international equity markets, simply looking at a map is inadequate—having a knowledgeable local guide is essential.

Residents of Vienna might be shocked to see visitors from the United States lining up outside Starbucks, only steps away from some of the world’s most famed coffeehouses. They shouldn’t be. Familiarity sells, and one can understand—if not completely forgive—the buyers for choosing the comforts of home over a more authentic local experience. But it’s only coffee, and the consequences of missing out on a better cup are small.

Experienced travelers understand that when seeking the most compelling experiences, simply looking at a map is inadequate; having a knowledgeable local guide is essential. The same can be said for international equity investing: Passive global benchmarks may have a comforting familiarity, but they offer little more than a chart of the world, devoid of local knowledge and insight.   

In the diverse and sometimes inefficient individual markets that make up the international equity opportunity set, broad index-based strategies may not be as effective as they are in some sectors of the U.S. equity market. They’re still available, of course. But they don’t offer targeted access across countries and regions to divergent top-down valuations, strategic diversification across markets and currencies, and large numbers of underappreciated firms. To gain that exposure, investors may need to forgo passive benchmarks—which tend to concentrate exposure in the largest markets and most highly valued sectors and firms—and consider active management.

Efficiency differs across markets

The U.S. domestic equity market is unusual in its depth and breadth. Numerous firms across virtually every industry sector allow managers to construct diversified portfolios in many styles: large, mid and small cap; growth and value; as well as in specific sectors of the economy, such as technology or health care. No other country offers as rich an opportunity set.

Equally important is the degree of financial scrutiny applied to public firms operating in the U.S. On balance, a firm with more analyst coverage will be priced more efficiently than one with less, and among a range of global equity markets, the U.S. has the deepest coverage by far (Exhibit 1). The U.S. market also includes a large population of active asset managers, an aggressive financial press and a regulatory regime that emphasizes disclosure and timely reporting of accurate financial data. 

The net result is unparalleled transparency and efficiency that allow analysts to accurately model firms’ financial performance using reliable data. The flip side, of course, is that the market’s efficiency makes active management more difficult because the odds are lower that a security is significantly mispriced.

Active managers have long been successful across all parts of the U.S. market, but investors’ general perception is that manager skill is more likely to produce positive results in less efficient segments and those that reward specialized insight and research. Thus, investors more commonly employ active management in sectors like small and mid cap or growth and value. In more efficient segments of the market, such as large cap stocks (the S&P 500), investors more frequently make use of passive strategies, placing their faith in the efficiency of the market itself.

Global markets present a different picture

Should this same logic apply to global portfolios? Studies show that international investments by U.S.-based investors have declined over the past decade and the majority of any new flows have been into passive vehicles.1 Yet, in many respects, the market characteristics that make passive investing an appealing proposition in the U.S. don’t apply as readily in other locales. Global markets comprise a heterogeneous set of individual country and regional markets that differ fundamentally from one another—and, notably, from the U.S.—with respect to their overall valuations, underlying efficiencies and alpha opportunities.  

Currently, many international equity benchmarks offer more attractive valuations than those available in the U.S. (Exhibit 2). Historically, however, this has often been the case, which forces investors to ask: Is this differential likely to narrow, allowing global equities to broadly outperform? We have reason to believe that the answer is yes—and that the process is happening right now.

The reasons for the historical underperformance of markets outside the U.S. vary. In Europe, sector distribution tilts toward less aggressively priced areas, such as financials and industrials; the U.S. index has a larger technology component. But this is only part of the story, because all sectors in the MSCI EAFE Index trade cheaper than those in the U.S. (Exhibit 3A). In Japan, domestic companies have been somewhat indifferent historically to traditional drivers of shareholder value; they also have an operational preference for holding large pools of cash (Exhibit 3B).

Such characteristics have historically differentiated international markets from the U.S., where  corporate management tends to focus more closely on creating shareholder value by various means, including the widespread use of share buybacks to enhance shareholder returns.

Change is already underway, however. For the first time in two decades, European equities are offering a higher buyback yield than U.S. equities, a strong indication that managements understand how cheap their stocks are—and how they can improve investor returns (Exhibit 4A). Similarly, in Japan, the overall return of capital to shareholders via dividends and buybacks is at (or near) an all-time high (Exhibit 4B). This dynamic is consistent with a widespread shift by Japanese companies to improve shareholder returns—in some cases at the direct behest of regulators. 

Value is not the only differential

Although global developed markets are associated with more conservative valuations, this does not imply a lack of individual growth-oriented investment opportunities—just that they tend to be available more cheaply. Across time, the Russell 1000 Growth Index has consistently traded with a higher price-to-earnings (P/E) multiple than the MSCI EAFE Growth Index, but also with higher volatility (Exhibit 5).

EAFE’s growth story is not simply a “low octane” copy of the U.S. version but, rather, a fundamentally different set of corporate exposures. EAFE growth companies tend to be far more multinational, with correspondingly diverse revenue streams (Exhibit 6). The diversification that this provides across multiple global business cycles can potentially improve resilience.

Genuine diversification within equity markets is valuable

These fundamental differences among markets suggest that investors have an opportunity to add diversification within their equity portfolios—not just outside of them. If anything, 2022 provided a warning that traditional stock-bond diversification can break down in a dramatic fashion, leaving ostensibly diversified portfolios subject to severe drawdowns. With that in mind, we think any possible source of diversification is valuable.

Although market wisdom often suggests that all equity markets are highly correlated, the evidence is more complicated. The broad U.S. market, growth and tech sectors are highly correlated (between 1.0 and 0.93), but their global market counterparts offer a materially better level of diversification. The MSCI EAFE Growth Index, for example, has just a 0.61 correlation with the S&P 500 and a 0.58 correlation with the Russell 1000 Growth Index (Exhibit 7).

Choosing the right equity market guide

Although a passive strategy might capture the top-down valuation differential between the U.S. and global markets at any point in time, it cannot target valuation differentials at the individual country level or capture value from fundamental research and security selection. Only an active strategy combines a global footprint with the benefit of analysts’ local knowledge in key markets. The size of that interpretive challenge is significant:

  • The global equity market universe currently comprises more than 58,000 listed companies—or more than 46,000 when the U.S. is excluded.2 
  • Performing fundamental analysis at the firm level is essential; so is an ability to compare firms in different locales that may compete globally.
  • Understanding country-specific and regional macroeconomic conditions is critical—but so, too, is an ability to parse accompanying currency changes.

Conclusion

The breadth and depth of the U.S. equity market may tempt domestic investors to undervalue the role of international equities in their portfolios, but this would be a mistake. Allocating outside the U.S. offers attractive target value, meaningful diversification and a powerful opportunity to generate alpha. Approaching this opportunity via a passive benchmark strategy is likely to be suboptimal; tremendous potential exists for active managers to allocate across diverse markets and to apply fundamental analysis to individual firms on a global scale.

As with travel, pulling out a map and finding your destination is simply the first step. Thoughtful planning—and enlisting the help of a knowledgeable local guide—make for a far more rewarding experience.

 

1 Cerulli Associates, “U.S. Investment Consultants 2022: Trends in the New Hybrid Work Environment,” The Cerulli Report, August 16, 2022.
The World Federation of Exchanges; data as of May 2022.