Through July of this year, the U.S. equity markets have posted returns of approximately 20%. This strong performance has led some clients to ask why we bother to diversify their portfolios, since this diversification into foreign assets (equities or bonds) has reduced performance this year. International stocks were up 9.6% through July—which would be great in most years—and emerging markets were down 8.6%. Thus, overall returns for diversified portfolios lagged U.S.-only equity portfolios.
The strong dollar hurt both asset classes. So, should we bring our cash home? Our answer is: no. If we did, we would be forgetting that emerging-market equities have led all asset classes in performance for seven of the last ten years!
Our Investment Principles
BWFA manages client funds by creating a diversified portfolio of stocks and bonds designed to meet our clients’ long-term investment objectives. Our goal is to earn market returns while reducing the overall volatility of the portfolio.
We diversify because we never know which asset classes will produce the highest returns for our clients. The best performer in 2012 was emerging markets, which is at the bottom year-to-date.
Portfolios that are diversified by asset class, industry, and credit normally have less risk because the correlation between these various asset classes is not uniform. The volatility of one asset class is often reduced or offset by another asset class. We know diversification is the right way to manage client funds, and our long-term results have shown that this strategy works well. However, it takes discipline to stay the course in a strong-dollar era that hurts foreign returns.
The Quilt of Market Returns
When we meet with new clients, we show them the Table of Equity Asset Class Returns as compiled by Eaton Vance. The most recent table shows returns by asset class over the last 10 years. It looks like a patchwork quilt. The returns are pretty random. The best performer one year may be the worst performer the next year.
Investors who “chase” returns by investing in the flavor of the month do so at their own peril. One would need a strong stomach to tolerate the volatility of a follow-the-leader strategy.
BWFA believes in diversification. It’s not that we can’t predict anything about the future—for example, BWFA is confident that interest rates will rise over the next few years as long as the economy continues to improve. It’s the timing of known events or the inability to predict wars or natural disasters that’s the problem. BWFA favors hitting singles and doubles by leaning in one direction based on the information we have, rather than swinging for the fences by assuming that we can outguess the market repeatedly.
The Strong-Dollar Era
After the market crash of 2008, the U.S. was quick to reduce interest rates and trash-talk the dollar in an effort to jumpstart our economy. The dollar fell 18% versus an index of our top 10 trading partners over the next two and a half years.
However, the weaker dollar did not help the returns on foreign equities that much. They were in the middle of the pack in 2009 and the bottom of the pack in 2010. At the time, other issues were playing a more important role. After suffering through two and a half years of embarrassment, the U.S. dollar hit bottom in August 2011, and it lost its coveted AAA status. Since then the dollar has rallied 11% versus its trading partners, despite of the Federal Reserve’s unprecedented Quantitative Easing program that aimed to weaken the dollar.
How did diversification of investment portfolios pay off during that time? As you may have expected, international equities were down 12% in 2011, as compared to a 2% gain for the S&P. But in 2012 emerging markets led all asset classes with a return of 18%. International equities were not far behind at 17.3%. All of this happened in a strong-dollar era!
Diversification, Diversification, Diversification
So if predicting the direction of the dollar correctly still doesn’t insure that you are invested in the correct asset class, then what can you do? You must diversify.
U.S. investors should have most of their funds in U.S. assets since that is the currency they spend. However when the dollar is strong, take advantage of the strength and buy foreign assets cheaply. Then you will benefit as the dollar weakens down the road.
If you rebalance over time, you will maximize the return of your portfolio. Demographics strongly suggest that most of the world’s future growth will be overseas. So don’t let short-term losses dissuade you from buying overseas.
Take advantage of the strong dollar. Do not become hostage to it.