March 2018 – Insights From A Quant

A slightly different version of this post, written with Chris Shuba and Joe Mallen of Helios Quantitative appeared here: IRIS

You are a US investor that wants to deploy some of your money overseas. You think international developed market stocks are attractive relative to US stocks, and you also think the US $ will decline over the period you intend to hold your investment. Your investment decision is logical to you. But you have choices: You could a) simply invest in a traditional index like the MSCI EAFE, b) invest in a fund that systematically emphasizes a particular factor like a value fund that only buys cheap overseas stocks, or c) invest in a developed fund that blends several factors together, like the JPMorgan Diversified Return International Equity ETF (JPIN). What is the best choice?

Investing in a traditional international market capitalization index like the MSCI EAFE is not a bad choice. It has delivered nice returns for a US investor, especially uncorrelated outperformance in the 1970s and 1980s, and helped to diversify a US-only portfolio.

Your second choice is to invest in one particular investing style because it makes sense to you. You might believe that a fund or index that chooses the cheapest or most attractively valued stocks based on metrics like Price to Earnings (PE) is best.

You could go find a discretionary portfolio manager who only buys stocks he deems to be cheap. Typically the concept of “cheap” is based on some absolute metric that the manager has in mind, such as never buying a stock with a PE greater than 15. If there are not enough stocks that are attractive, he will hold his money in cash until he finds the prudent bargains he seeks. This prudence also obviously risks possible underperformance from being absent from the market.

The alternative is to buy a value index or fund that systematically only buys the cheapest stocks in a particular investment universe. So if there are 1000 investable stocks available, the index ONLY buys the cheapest decile of 100 stocks and is always fully invested in the 100 securities that are relatively cheapest. This is an investment approach that a discretionary manger may disdain. The discretionary value manager may look at those same 100 stocks and think they are pricey. But nevertheless, academic research has shown that always being fully invested in the relatively cheapest percentiles of stocks in the US has produced superior returns over many decades.

Such a portfolio is called a “factor” portfolio. Why the name? In the early 1960s, academics introduced the concept of beta and demonstrated that individual US stocks had sensitivities to, and were driven by, movements in the broad market. In the early 1990s, academic research began to show that other “factors” such as value and size also drove US stock returns. Since then, several factors have been identified as driving individual stock outperformance: value, size, volatility, momentum and quality. Stocks that are cheaper, smaller, less volatile, have more positive annual returns and higher profitability have historically outperformed their peers. It turns out these factors also work internationally.

Of all the factors, value is the factor that has been the best known the longest (even before it was academically identified as a “factor”), thanks to the books of Warren Buffet’s teacher Ben Graham. And if you look abroad at an array of developed global markets and create a value index and compare it to its simple market capitalization weighted brother, the historic outperformance of value has been stunning. Until recently.

While there was some variability by country, on average from the mid-1970s up until 2005 a value factor portfolio in a developed market outperformed its market cap weighted index by about 2% a year. That’s a lot. By contrast, since 2005, the average developed country value portfolio has underperformed a market cap indexes by about -40 basis points. Which is the danger of investing in one factor. It may not always work at every point in time.

So if investing in one factor like value runs the risk of underperforming, how about a multi-factor international developed equity portfolio?

Below is a breakdown of individual factor portfolios’ performance in international developed equity markets since 2005, an equal weighted factor portfolio as well the performance of the MSCI EAFE as our performance reference. Note that, for the last 13 years, value has been the poorest factor by far, while the others have handily beaten the EAFE. An equal weighted portfolio of all 5 factors, while not as optimal as some of the individual factor results, beats the EAFE by 1.6% and has an information ratio, or risk adjusted returns that are superior by 37%. The equal weighted factor portfolio also has the advantage of not having to predict which factor will work when, so even when a factor like value does not beat the market, the other factors can pick up the slack.

The equal weighted factor portfolio has one other advantage over the market cap weighted alternative. Note in the chart below how well the portfolio outperformed in the 2008 crisis, so it tends to do relatively well in highly volatile sell offs.

While it’s not inconceivable that one or two of these factors could erode, or underperform for a stretch, the fact that you have exposure to multiple factors in a portfolio that seems to do especially well in crises suggest the multi-factor blended portfolio remains the most attractive way to invest in developed markets.

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This article was written with Chris Shuba and Joe Mallen of http://heliosdriven.com/ And has appeared here in ETF Trends

When considering how currencies affect US $ portfolios, one must think about four things:

Buying a foreign currency asset is a bet that the US $ will decline.
The longer-term contribution of currencies to portfolio returns and volatility can be substantial.
Some currencies have hidden regime jumps or shock risks.
Will the US $ decline or rise the currency you invest in.

First, quite unlike stocks or bonds, currencies have no inherent value, only relative value, and when you make a relative value investment, you bet on one instrument rising more than another. That is because a currency only has value relative to what it can be exchanged for, whether that is the Japanese Yen, Gold or Bitcoin. Thus, putting money in a foreign currency means that you are implicitly expecting that currency to rise relative to the dollar, or for the dollar to fall relative to the currency that you bought.

For example, when you buy a broad non-US ETF like JPMorgan Diversified Return International Equity ETF (JPIN), you assume that over time a diversified basket of global stocks will rise, and simultaneously assume that the US $ will fall in value. The changes in both the portfolio of stocks and the portfolio of exchange rates affect your $ PL. In the example given, let’s say it’s a global stock market holiday and every equity market in the world closes for a 4 day weekend, but the currency markets remain open. Over that long weekend, the value of the stocks in JPIN will remain unchanged, but a 3% decline in the value the US $ relative to the currencies in the ETF will cause the value of your investment in JPIN to increase by 3% in dollar terms.

Second, while one might not think that exchange rates contribute to a long-term investment in an asset in another currency, the fact is they do. Consider the table below, which shows the annual volatility of the exchange rates of several countries vs. the US $, as well as the annual volatility of long-term bonds and stocks in the same country.

As you can see in the first table, Annual Volatility of Three Assets Since 1973, on average, the annual volatility of long-term (10 year) bonds in major developing countries has been about 7% vs. 11% for the currency. For stocks, the average annual volatility has been 18% vs. 11% for the currency. However, it is the second table, The Volatility Contribution From the Currency to a US $ Investor’s PL in Foreign Bonds & Stocks, that tells the real story. On average, 61% of a US investor’s foreign bond PL is determined by changes in the exchange rate, with only 39% coming from the performance of the bond itself. That is the majority. So, if you buy foreign bonds, it makes sense to hedge. With stocks, more than a third or 37% of a US investors PL is driven by the currency change. Put another way, 37% of your foreign stock PL is being determined by a factor that is extremely hard to predict.

Third, currencies occasionally make large, unexpected moves. These large changes are usually a currency devaluation relative to the US $, though not always. Latin American currencies, in particular, have a long and colorful history of dramatic collapse. Devaluations naturally cause a US $ investor to lose money on the currency part of their investment. Also, devaluations are usually inflationary and negatively impact holdings of local bonds, because local interest rates typically will rise. The impact of a currency shock on local equities is not always as predictable. Stocks that are highly dependent upon local or foreign currency debt, fall as rates rise and their foreign debt obligations increase, but an export company with little debt will likely see its share price skyrocket because the firm is now internationally more competitive.

For US investors, currency shocks are not always an emerging market issue. In the last few years, the UK and Switzerland have both experienced significant sudden changes in their currency value, because of the Brexit vote and an abrupt change in Swiss Central Bank policy. Should Denmark suddenly decide to uncouple the Krona from the Euro, or Hong Kong or China decide to make their currencies more free-floating, there would be massive changes in the exchange rate. These large potential changes in currency value, whether in emerging markets or the developing world are something investors need to be aware of.

Finally, one must consider the future direction of the US $. If it declines, foreign currency investments gain in dollar value, and if it rises, these same investments decline in dollars.

On the one hand, the US $ has some major pluses. For now, at least, it remains the world’s reserve currency. Our relative geographic isolation means the US is where funds typically come in times of geopolitical trouble.

US growth is strong relative to much of the developing world, which makes it attractive to capital seeking higher growth rates. And, the US Central bank is raising rates, so it is attractive from a relative interest rate perspective.

On the other hand, the US $ has declined a great deal vs some major trading partners over the last 40 years. In the 1970s, a dollar bought up to 360 Yen; now it buys 110. In the late 1980s, one US$ could buy 10 and even 12 Renminbi on the black market; now a dollar buys 6.5 Renminbi. Over the long-term, countries with high savings rates and current account surpluses tend to see their currency rise relative to countries with low savings rates and large current account deficits (who must fund their spending by importing capital from abroad).

The US Current Account is still in the red (though much smaller than several years ago), and US savings numbers have improved. That said, remember that currencies are a relative value investment. Compared to thrifty East Asia, the long-term US numbers are not as attractive. The fundamentals for the rest of the world relative to the US are not as crystal clear.

The US currency is also affected in the short-run by both current political policy and the business cycle. Trade wars and ballooning public deficits don’t inspire confidence among foreign investors. And if foreign investors choose to keep their money at home, it would cause the US $ to decline and US interest rates to rise.

Inflation and higher interest rates are the other related factors that will impact the US $ in the near term. As noted above, higher relative interest rates and relative growth rates have attracted foreign capital to the US. But if there is the perception that these higher rates of growth and yields are being eroded by uncontrolled inflation, and that the Federal government cannot control its spending and the Fed is behind the curve, foreigners will reduce their US investments. Inflation, when it is perceived to be too high, will cause a currency to lose value, because it destroys purchasing power. Unfortunately, trade wars as well as a decline in the US $ can further exacerbate inflation by making imports more expensive. To date, we have not seen a run on the dollar or inflation reach a dire tipping point that would drive interest rates up and asset values down, but the probability of this happening has increased.

Will the next 40 years look like the last 40 years for the US $? No one can know for certain. However, in a future post article, we will show how this gradual decline in the US $ has been one of the major benefits US $ investors have gained in the past by putting their money to work in foreign equities.

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