Is There Still a Case to Diversify Away From U.S. Equities?

Summary

  • Poor past performance seems to have dented the appeal of non-US developed or EAFE equities. High correlations have also seemingly reduced the benefit of diversification.
  • However, past performance, particularly once we allow for style and sector biases, is offering a poor rear view mirror to set regional equity allocations for today’s equity portfolios. EAFE allocations now are more likely to be portfolio enhancing, diversifying risk across sectors and reducing the risks from excessive home bias and recommend global market cap weights from a strategic perspective.
  • Valuation fundamentals favor EAFE equities over the US. Earnings have more potential to climb than in the US, though there are headwinds to both equity markets.
  • Though the US dollar may have some more near-term climbing to do, our longer-term view continues to see a tendency towards dollar weakness, rather than dollar strength. This is likely to be mildly helpful for non-US market returns.
  • Many US institutional equity portfolios, particularly corporate plans, are more US-centric today than they should be. A slow build of non-US allocations towards global market capitalization weights in the first instance seems to be a good first step.

Background and Scope

Most US investors have been gradually building up their allocations to non-US developed equities, commonly referred to as EAFE1 , over recent years but, as the table below shows, there are stark differences in the degree of home bias between plans by sponsor type and size. In particular, corporate plans tend to have allocated much less to non-US equities than public plans, as have smaller plans by asset size.

In this paper, we test the assumption that greater non-US exposure improves risk adjusted outcomes and highlight that performance differentials that have been in favor of the US in recent years, have seemingly weakened the case for diversification away from the US. We will highlight the challenges to diversification and provide our strategic view, as well as our medium term (1-3 year) view. This note will not cover the case for or against Emerging Market equities and focuses solely on developed world equities as this is where the focus of debate has been in recent years; our regular Medium Term Views updates provide information on emerging markets for those that are interested. 

To learn more about this topic, download the full whitepaper above. 


1 The acronym EAFE stands for Europe, Australasia and the Far East. The MSCI EAFE index covers all developed equity markets excluding the US and Canada. It is essentially the MSCI World index excluding North America.


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Disclaimer

This document has been produced by Aon’s Global Asset Allocation (GAA) Research Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon to be reliable and are not necessarily all inclusive. Aon does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

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