In today’s defined contribution marketplace, the byword for many plans is simplification—reducing the choice “build-up” that has occurred over time while still providing access to options that they believe most readily capture the potential returns tied to diverse markets. Obviously, some nuance may be lost as the various ways to slice and dice a portfolio are abandoned by plan sponsors in an effort to encourage easier selection and, by extension, assist participants in creating more effective allocations.
Simplification must therefore come with particular attention to manager selection so that a given strategy, run by one team of professionals, can provide access to non-U.S. markets across region, style and market capitalization. This may extend to emerging markets, where participants may be less knowledgeable but see value in greater diversification and return potential. In short, it is especially important that plan sponsors make their menu options count—nowhere more so than if they seek to provide exposure beyond the U.S.
Executive Summary
- U.S. investors have benefited from a home market bias since the Global Financial Crisis of 2008 as international markets have lagged U.S. counterparts. However, deteriorating U.S. dollar fundamentals coupled with a vast opportunity set abroad suggest that the benefits of global diversification could reassert themselves.
- Unlike managers of passive vehicles, many active managers aim to avoid the concentration risk associated with indices while exploiting market inefficiencies to deliver alpha.
- Managers with flexibility across the style and capitalization factors of a strategy can help make plan participants’ choices simpler and improve risk/reward outcomes; they can sometimes provide exposure to M&A activity, which is typically concentrated in smaller companies.
- Given ongoing challenges to the global economy, staying focused on individual business fundamentals while emphasizing quality names can help manage downside risk while providing participation in positive markets.
- Still, valuations of many “overcrowded” growth businesses are elevated, making them vulnerable to higher interest rates. Broadening exposure to other types of quality companies can mitigate some of this risk.
Looking for Meaningful Diversification
How can a plan menu be structured to capture opportunities across the global equity universe? Many DC plans tend to have a home country bias when it comes to menu options—with plenty of domestic options but few overseas. Even in their non-U.S. options, there is a temptation to include a global equity strategy as an easy way to capture U.S. and international exposure. Although appealing on its face, the downside is that such a choice may compound home country bias and create the potential for strategy overlap. We therefore believe it’s important to have a dedicated international option that’s distinct from the standard U.S. equity weightings that many investors view as the core of their portfolios.
Benefits of Active International Investing
As part of menu simplification, many plan sponsors are carefully assessing whether to go with active or passive management in various market segments. A key consideration is the potential for alpha in relation to fees, which will often influence the use of a given strategy within a given plan. Plans often provide passive options in a category where individual equities are well researched, and ample information flow arguably makes it difficult for active managers to gain an edge. In contrast, they may believe that it is easier to justify an active management option in a category where successful managers have generated meaningful outperformance versus their benchmarks. Figure 1 shows that international equity is just such a category, in our view, making fees relatively reasonable versus passive strategies given the potential for alpha. Top-quartile active managers in large cap international blend and growth categories have provided greater excess returns than their U.S. counterparts over the past 26 years. U.S. large cap value managers have had more success, partly due to style drift, where owning one or more of the mega-cap tech giants that have been enormous outperformers have helped them outperform value benchmarks that do not contain those big tech names.
FIGURE 1: TOP-QUARTILE MANAGER AVERAGE EXCESS RETURN ROLLING 5 YEARS, 2006 – 2020
Source: Morningstar. Data as of 12/31/2021.
Market Cap and Style Flexibility Can Expand Opportunities
A major challenge in plan simplification is to reduce the number of investment options (to make selection by participants easier) while still providing access to the widest set of investment opportunities that allow for diversification across market capitalization, domestic and international markets and even emerging markets. In the international space, a plan could easily construct a menu with separate options for small, mid- and large cap investments, and growth and value managers. In theory, a plan could have dedicated options within emerging markets as well; however, doing so would create multiple menu options, requiring participants to understand each, and how to allocate across them. Accordingly, within international equities, where options will likely be limited, our belief is that offering a single manager with flexibility across the style and capitalization ranges—rather than separate options for each—could make participants’ selection process easier. While delivering breadth across the asset class for the participant, a wider universe may also offer the manager additional opportunities to generate alpha. Smaller companies that are followed by fewer analysts, for example, may provide the potential for superior returns.
As shown in Figure 2, small cap stocks have outperformed in all but three years since the Global Financial Crisis. However, since small and mid-caps have had periods of significant underperformance, we believe that selectivity tied to valuation discipline and risk management is key in this area.
FIGURE 2: INTERNATIONAL SMALL CAP STOCKS HAVE OUTPERFORMED LARGE CAPS
MSCI Small-Cap Performance Differential vs. Large-Cap (%)
Source: Morningstar. Data as of 12/31/2021.
A similar point can be made with regard to style segments. As shown in Figure 3, the MSCI Growth and Value indices have tended to trade places, most recently with Growth providing the stronger returns. Rather than leaving it up to participants to follow market cycles and allocate appropriately, we believe that employing a core investment approach that can draw on both segments may offer the potential to improve investment returns. In our view, combining flexibility on style and size may deliver superior returns and lower volatility, as well as ease the burden on participants.
FIGURE 3: PERFORMANCE-STYLE LEADERSHIP OFTEN CHANGES
MSCI Growth Performance Differential vs. Value (%)
Source: Morningstar. Data as of 12/31/2021.
Capitalizing on M&A
Part of the appeal of smaller and mid-cap stocks is their potential to benefit from mergers and acquisitions (M&A) activity. M&A activity is buoyant globally as rates have remained low, private equity fundraising has been robust and companies with large cash balances look externally for growth. While much of the recent activity has centered on the U.S., momentum is also strong in Europe and Asia.
However, the benefits of M&A are not distributed evenly across companies. While the percentage of total transaction value is skewed to larger companies, the number of transactions is typically weighted toward smaller deals. It appears that purchasing smaller firms is believed to entail less risk for acquirers, contributing to their appeal as M&A targets. A multi-cap international equity portfolio may give participants a greater opportunity to benefit from the potentially increasing level of corporate activity in a greater number and geographically diverse set of companies.
Accessing Emerging Markets Through International
Another area that aims to provide opportunity for participants is emerging markets (EM) equity. While informed participants can allocate to dedicated EM managers at the right time, and are cognizant of the risks involved, for others a strategy that combines select exposure to this market segment within the context of an international portfolio may make sense. As with the style and size examples above, performance of EM relative to U.S. and international stocks has tended to go in cycles; consistent and/or managed participation in EM may help improve returns when EM is performing well, while managing risk when EM returns fade, as they did in 2018 and 2021.
FIGURE 4: MSCI EM ANNUAL RETURNS (%, NET)
Source: Morningstar. Data as of 12/31/2021.
In Dispersion, Focus on Fundamentals and Quality…
For extended periods after the Global Financial Crisis of 2008 – 2009, markets, countries and securities exhibited high correlations, as generally loose monetary policy and broad macro concerns dominated the markets. Given the uneven nature of the global recovery following the COVID-19 pandemic, however, in our view individual company fundamentals are becoming a more important driver of market performance, which should play to the strength of international managers focused on finding superior stocks. In particular, we believe that the current environment calls for a quality orientation based on the idea that high-return (e.g., ROE, ROIC) companies with attractive bottom-line growth and modest levels of debt can effectively not only meet ongoing challenges, but even broaden and strengthen their economic profiles.
Mitigating downside risk is critical to participants’ ability to reach successful retirement outcomes. We believe that an investment approach focusing on fundamentals and quality may provide participants with the ability to take part in up markets while helping to minimize exposure on the downside.
…But Do Not Ignore Valuation
The caveat to this is that high-quality stocks have been significant outperformers over recent years, and valuations look rich in traditional quality businesses. Investors have migrated toward these stocks in search of resilience during the COVID-19 crisis and at the end of an exceptionally long business cycle. By the end of December 2021, the MSCI EAFE Quality Index was trading at a 43% premium relative to the EAFE index (figure below), which may leave the stocks vulnerable to a change in investor sentiment or a move higher in interest rates, which may, as we saw in the fourth quarter of 2020 and in the early weeks of 2022, put significant pressure on quality and growth stocks.
FIGURE 5: TRADITIONAL QUALITY TRADES AT 43% PREMIUM
Premium/discount of MSCI EAFE Quality Index Relative to the MSCI EAFE Index, based on the two-year forwards P/E Ratio
Source: Bloomberg, MSCI. Data as of 12/31/2021.
Here lessons can be drawn from the U.S. market in the 1970s. The Nifty 50 were a group of high-quality stocks that, in a period of economic volatility, were bid up to very high valuations. Eventually, the enthusiasm for the Nifty 50 subsided and that group of stocks underperformed the S&P by 40% between 1973 and the end of that decade. This highlights the concentration risk associated with an oversimplified view of these traditional markers of quality.
FIGURE 6: THE NIFTY 50 DID NOT RECOVER THEIR 1973 HIGHS FOR THE REST OF THE DECADE
Source: Exane BNP Paribas estimates, DataStream.
In our view, expanding into less appreciated quality businesses—either down the capitalization spectrum or in sub-segments of industries that have underperformed but still offer attractive growth and cash flow characteristics—at more attractive multiples offers investors better diversification and greater future return potential.
Flexibility Can Support Simplicity
The notion of plan simplicity is a bit of a contradiction. The global economy is not simple, markets are not simple and the challenges faced by investment managers, plan sponsors and participants are not simple. And yet, for a defined contribution plan to succeed, the choices before a participant must be straightforward enough to avoid confusion, and more importantly, to prompt appropriate allocations that, over time, will lead to successful retirement investment outcomes.
In our view, a flexible, fundamental and active multi-cap approach to international equity investing offers many positives for participants in the current investment environment. While this approach capitalizes on market dispersion, layering on a disciplined focus around quality aims to help manage downside risk while providing capital appreciation potential. More specifically, it expands the international universe in a single investment option, enabling opportunistic investing within the widest possible investment universe, with the flexibility to be opportunistic regarding off-benchmark segments like small and mid-caps. In sum, it offers the potential to distill the complexities of non-U.S. stocks into a single investment option that participants can understand and hold for the long term.
