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Key Takeaways

  • Strong U.S. equity market performance has presented a rebalancing opportunity toward non-U.S. developed markets – beyond conventional reasoning about valuations, earnings growth, and pandemic policy responses.
  • We believe you can take advantage of favorable structural market conditions in non-U.S. markets, including a potential rotation in regional returns, stable capital distribution, and healthier market breadth.
  • We show that many active managers have found recent success in these markets, but we believe few have the discipline to capitalize on these opportunities and/or have a long enough track record that gives you confidence that it's possible.

Hitting over 30 all-time highs in U.S. equity markets this year may get you a bit closer to your funding, spending or plain happiness goals, but they may also invite an asset allocation problem, as the U.S. has considerably outperformed many non-U.S. equity markets. The Russell 1000 Index has given investors a 40.5% cumulative return advantage over the MSCI EAFE Index in just the last three years (Figure 1).

Has your non-U.S. equity allocation changed?

Blog-Time to Check Your Global Allocations_Fig_1

Rebalancing for Opportunity

It's no secret that Intech advocates diversification and rebalancing, but it's not just for risk management. Rebalancing offers you an opportunity as well. It’s always essential to keep your policy allocation on track, and thoughtfully rebalancing to non-U.S. developed markets offers upside potential for reasons overlooked by conventional managers.

Traditional arguments may point to relative valuations, earnings growth, and improving pandemic conditions across non-U.S. developed markets, but these might miss what we see as a structural opportunity for the right active management approach: long-term diversification, lower capital concentration, and better market breadth. We believe these factors lay an excellent foundation for alpha potential.

Long-term Diversification

Many investors have found the benefits of international diversification elusive over the last ten years. Over the long term, however, regional markets do not always move together and have provided diversification benefits.

A 5-year rolling return comparison between the Russell 1000 and MSCI EAFE Indexes gently illustrates the point (Figure 2). Regional market performance advantages can last for years, especially when accounting for currency exposure. For U.S. investors, a falling U.S. dollar after the turn of the century helped support EAFE's return advantage until the global financial crisis.

Blog-International Diversification_Fig_2Since then, the opposite has been true. The current advantage of U.S. equity market performance over non-U.S. developed equity markets is unprecedented, and many pundits have rationalized a new normal. But as long-time market observers, we contend that markets usually succumb to their historical patterns.

 

More Stable Capital Distribution

Capital distribution in equity markets has been remarkably stable over the long-term. Smaller-cap companies may become larger and larger-cap companies may become smaller. Still, over the long-term, no stock or group of stocks persistently dominates, given the collective stability in capital distribution across markets.

More recently, however, investors in U.S. equities have been continuously allocating capital to the largest stocks, making the environment challenging for risk-aware, diversified active managers. For example, over the last several years, active managers likely trailed the index if they underweighted the largest U.S. technology names. Conversely, investors in non-U.S. equity markets have distributed capital consistent with historical allocations. The non-U.S. equity markets present an opportunity for investment processes that seek to diversify risk systematically. The differences in capital distribution couldn't be starker.

Blog-Stark Differences in Capital Distribution_Fig_3

More Consistent Market Breadth

Market breadth can be considered the first cousin to capital concentration. It indicates the relative change of advancing to declining securities in the market. And it's been narrow in U.S. equity markets. For example, despite the new all-time market highs in the U.S. markets, only 29% of U.S. stocks in the Russell 1000 Index outperformed the benchmark in Q2 2021 – a significant drop from the prior two quarters (Figure 4).

Again, the opposite is true for the MSCI EAFE Index, where investors have experienced more consistent and broader market breadth. Such an environment offers a favorable opportunity for active managers to generate excess returns for clients.

Blog-Equity Market Breadth Comparison_Fig_4

Alpha Potential

Stable capital concentration and wider market breadth offers opportunity for conventional active management to generate excess returns through stock selection, as the range of stocks outperforming the index increases.

But these factors are also favorable for diversification, which is alpha potential in Intech parlance. How do you get alpha from diversification? It’s easiest to understand by breaking down compound returns.

We all know an index's compound return is more than the weighted compound returns of its underlying stocks. The difference comes from portfolio effects, derived from the volatilities and correlations of its stocks – aka diversification (Figure 5).

Blog-Alpha Potential From Diversification_Fig_5

With cap-weighted indexes, there's quite a bit of diversification opportunity left on the table because they don't explicitly consider volatilities and correlations in their construction methodology. Intech seeks alpha simply by re-weighting index stocks more efficiently and rebalancing them systematically. The opportunity is ever-present, but the MSCI EAFE Index in particular and the current market regime increase that potential.

Blog-EAFE_Download Paper-1So, Do You Have the Right EAFE Manager?

Many active managers have found success against the MSCI EAFE benchmark recently; therefore, researching this space may not seem like a high priority right now, but inferences about favorable performance often arise from universe misspecification. And there is plenty of that going on in this popular category.

Apply Three Prudent Screens

eVestment makes correcting this problem easy by using a few simple screens (Figure 6). First, find the group of strategies designed to fit your policy allocation, by using these manager-stated data points:

  • Preferred Benchmark = EAFE
  • Style Emphasis = Core

Boom. You shrink the universe of strategies by almost half, from 139 strategies to 85.

Blog-Filtering EAFE Large Cap Core Universe_Fig_6

Now, you can examine performance. For relative return strategies, positive information ratios help you cut to the chase because they tell you two important things:

  • Did the manager beat the benchmark?
  • Did the manager outperform consistently?

But make sure they have a long track record by screening for a positive information ratio on 3-, 5- and 10-year trailing periods. That cuts the universe down to 22 strategies overseen by just 18 managers.

Blog-Why EAFE-1-1

Pick Your Pleasure: Similar Success, Yet Different Paths

The best thing about this group of successful strategies is that they don’t all “fish in the same pond.” In other words, you can get uncorrelated sources of alpha by combining two or more of these strategies.

We’ve already described Intech’s unique alpha source, but don’t depend on investment process narratives. Look at the data. Again, using eVestment, we can easily examine the excess return correlations for these elite strategies over multiple time periods. Below is a table for their 10-year correlations (Figure 7), but shorter time periods produced similar results.

Blog-10-Year Excess Return Correlations of Screened EAFE Managers_Fig_7

Yes, Intech’s in This Group

Intech has been navigating EAFE investing for nearly 15 years with the same lead portfolio managers and the same investment process. And we believe all that sameness has contributed to consistent results, giving our clients less governance anxiety.

Respecting Your “Time is Money”

We expect Intech International Large Cap Core to underperform in the short- and medium-term, but we also expect that underperformance to average away over longer time-horizons. Historically, patient investors have been rewarded with higher probabilities of excess returns. 82% of 3-year rolling excess returns have been positive since inception; 100% of 5-year rolling returns have been positive since inception (Figure 8). And these figures are NET of fees.

Blog-Net of Fees Batting Average Over Rolling Time Horizons_Fig_8

Performing in Up and Down Markets

Five-years can be a reasonable proxy for a market cycle, so let’s breakdown the 5-year rolling net-of-fees returns above to see WHEN Intech International Large Cap Core outperformed its benchmark (Figure 9). Consistent with the chart above, our strategy outperformed the MSCI EAFE Index 100% of the time, but now you can see that it occurred in BOTH up and down EAFE markets.

Blog- EAFE-Annualized Rolling 5-Year Net of Fee Returns vs MSCI EAFE_Fig_9Shooting for Efficiency, Not the Stars

Typically, investors’ patience with their managers is directly related to their tolerance for active risk; unfortunately, more tracking error does not necessarily mean more alpha – even after 10 years. We can demonstrate this challenge among EAFE managers. Figure 10 compares EAFE managers’ 10-year tracking errors and excess returns. The range of outcomes increases with an increased active risk, especially when you consider the higher fees often associated with higher active risk strategies.

Blog-Excess Return Outcomes Widen with Active Risk_Fig_10

Therefore, we wouldn’t recommend using tracking error to screen EAFE managers. Ultimately, you should focus on information ratio because it reveals excess returns per unit of active risk, which demonstrates your manager’s skill in outperforming and the efficacy of your manager’s investment approach. International Large Cap Core takes moderate active risk, designed to give you results that are more consistent over time (Figure 11).Blog-Intech International Large Cap Core 5-Year Rolling Net of Fees Information Ratio_Fig_11

Conclusion

A rebalancing opportunity toward non-U.S. developed markets is at hand, and supported by favorable structural market conditions, like a potential rotation in regional returns, a normal capital distribution curve, and steadier market breadth. But few active managers have proven, long-term track records and consistent, disciplined processes to capitalize on these opportunities. We encourage you to discover how Intech International Large Cap Core is prepared to do just that.

Blog-Intech International Large Cap Core Net of Fees Performance_Fig_12

Learn More

We invite you to learn more about Intech International Large Cap Core and the diversification potential in non-U.S. equity markets.

Blog-EAFE_Bio_McHugh_375Blog-EAFE_Bio_Candinali_375


Diversification Potential: Untapped Alpha in Non-U.S. Equities  A new measure for overlooked returns. Download Paper

 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Blog-EAFE_Composite Performance

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and do not purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons.

Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Information that is based on past results or observations is not necessarily a guide to future results, and no representation or warranty, express or implied, is made regarding future results.

Intech performance results shown reflect the reinvestment of dividends and other earnings, are time-weighted rates of return using daily valuation, include the effect of transaction costs (commissions, exchange fees, etc.), and are gross of non-reclaimable withholding taxes, if any. For periods of less than one year, performance is not annualized. Reporting currency is USD.

Net performance results presented reflect the deduction of model investment advisory fees, and not the advisory fees actually charged to the accounts in the strategy. The model advisory fees deducted reflect the standard fee schedule in effect during the periods shown, applied to each account in the strategy on a monthly basis. Standard fee schedules are available upon request by contacting Intech at Finance@intechinvestments.com. Actual advisory fees paid may vary among clients invested in the same strategy, which may be higher or lower than the model advisory fees. Some accounts may utilize a performance-based fee.

Prior to May 21, 2010, with respect to non-U.S. securities traded on non-U.S. exchanges, Intech used fair value prices that reflected current market conditions at the end of regular trading hours of the NYSE, normally 4:00 PM ET, rather than unadjusted closing prices in local markets. Therefore, the prices as well as foreign exchange rates used to calculate the U.S. dollar market values of securities may have differed from those used by an index. Indices generally use the unadjusted closing price in local markets instead of fair value pricing. As of May 21, 2010, prices for non-U.S. securities traded on non-U.S. exchanges are typically valued as of the close of their respective local markets. However, if a significant event takes place between the close of the local market and the close of the U.S. domestic market, a security may be fair valued. Non U.S. securities are translated into U.S. dollars using the 4:00 P.M. London spot rate.

Index returns do not reflect transaction costs or the deduction of fees. It is not possible to invest directly in an index. 

Investments are subject to certain risks, including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations.

This material has been developed solely by Intech and are not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group©”). FTSE® and Russell® are trademarks of the relevant LSE Group© companies and are used by any other LSE Group© company under license. All rights in the FTSE/Russell indexes or data vest in the relevant LSE Group© company, which owns the index or the data. Neither LSE Group© nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in these materials. No further distribution of data from the LSE Group© is permitted without the relevant LSE Group© company’s express written consent. The LSE Group© does not promote, sponsor, or endorse the content of these materials.

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