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Why Diversification Wins

Cambridge Associates

Lessons from Fiscal Year 2017 Results

Diversified investors are noticing quite a difference in 2017 fiscal year performance—and it’s a welcome change.

In the midst of an extended US equity market, and with returns that many diversified investors have found hard to swallow over the last few years, the turnaround in annual performance for what is many investors’ fiscal year—12.7% on average this year versus -2.4% average returns for the same period ending June 30, 2016[1]— has given long-term investors a moment to breathe a small sigh of relief.

While one year does not make a market cycle, this positive turnaround in performance reminds diversified investors why their approach works and is worth sticking with for the long term:   results can and often do turn dramatically and quickly, and investors who remain committed to a diversified approach are best positioned to benefit from the variable nature of market leadership.

Don’t look now, but US equities just got outperformed

This year, the shift in performance for diversified investors has been largely driven by their allocation to non-US equities, and particularly emerging markets.  That is not to say that US equities have ended their seemingly unstoppable rise—the S&P 500 remains up 17.9% for the one year ending June 30, 2017. But contrast that with the MSCI All-Country World ex US Index, which was up 21% in USD terms—more than 300 basis points of outperformance relative to the S&P.

Disciplined value-based investors are not very surprised by the turnaround in non-US equities, which skyrocketed from a one-year return of -0.4% as of June 30, 2016.  In fact, many of them planned on it.  Non-US equities had taken quite a beating over the past few years given an earnings recession in many countries, concerns that the plummeting oil price would damage commodity-driven economies, fears over a potential EU breakup, and a variety of geopolitical concerns.  Consequently, emerging and non-US developed markets equities were trading at discounts that were at some of their widest margins in history relative to US counterparts.  For disciplined, contrarian investors, these valuations helped them to fight the urge to cash out and chase US equity returns and, in many cases, instead choose to lean into non-US and emerging markets allocations when valuations were nearly begging them to do so.

Those decisions appear to be paying off.  With the combination of improving economic results, strong earnings growth, attractive valuations, and investors’ perception about the stabilization of major geopolitical risks in Europe, non-US equity markets have been trading substantially higher. In fact, US equity outperformance peaked in November 2016, raising the prospect that the cycle has indeed turned. For the first half of 2017, developed markets outside the United States have outperformed US equities by a comfortable margin (12.8% versus 9.2% through June 30) and emerging markets equities have outperformed by more than twice that margin in USD terms.

And it doesn’t appear to be over just yet.  With US equities very overvalued, the valuation gap between the US and international markets remains historically wide. Combined with positive economic and earnings momentum outside the United States, investors with an overweight exposure to non-US equities relative to US equities will look to benefit from that asset allocation decision even more going forward.

Of course, diversified investors still often maintain meaningful exposure to US equities as part of their overall global equity allocation (with the strategy accounting for 22.5% of the average asset allocation for clients who participated in Cambridge Associates’ quarterly asset allocation and return survey as of June 30, 2017).  That means those investors were able to reap the benefit of both US and non-US equity performance from sticking with a truly global equity allocation.

Hedge funds are showing signs of life

While the rebound in non-US equity performance has been highly rewarding, the performance turnaround isn’t limited to global common stocks—diversified investors with exposures to hedge funds are seeing significant performance rebounds as well. Admittedly, it’s been tough slogging for the hedge fund industry for the past few years, with one widely cited measure of hedge fund performance, the HFRI Fund-of-Funds Composite Index, returning -5.4% for the one year ending June 30, 2016. Funds in the index fared better in 2017, as the HFRI returned 6.5% for the one year ending June 30, much closer to the high single digit performance that diversified investors expect from this portion of their asset allocation.

Times of stress also provide opportunity.  For example, some investors have been able to gain access to hedge fund managers who had long been closed but were suddenly in a position to selectively open to new investments as the industry contracted.  The strain on the broader hedge fund industry has also allowed for more negotiations on fees and terms over the last 18 months as LPs or their advisors were able to leverage the shift in the industry to their advantage.  These opportunities are likely to continue contributing to the success of these investors in the years to come.

It’s déjà vu all over again

For more in-depth views from Chief Investment Strategist Celia Dallas, read the most recent edition of VantagePoint.

It can be tempting for investors to forget history when they are living through a current bull market and, as is typically the case during strong US-led equity rallies, simple US stock/bond portfolios have appeared to win for the last few years. Many investors questioned the diversified approach in the late 1990s, when the sustained bull market from 1995 through 1999 led to simple portfolios generally outperforming diversified ones for an extended period of time.

But, the long-term investors who remained disciplined and committed to the diversified approach ultimately fared better over the following 20 years.  We have seen this movie before—and we have no reason to think that the ending will be different this time.  Without valuation discipline, investors crystallize underperformance by selling assets that are undervalued to put that money into overvalued strategies. Then, when undervalued assets begin to deliver, those investors further miss out on that resulting upside because they have already cashed out of the strategies that are now delivering.

For all investors, the last year is an important reminder—and reassurance—about the benefits of remaining patient through market cycles. Of course, as good investors know, one-year performance shouldn’t be over interpreted—for better or for worse.  It is crucial to remember that long-term return targets are averages. Portfolios will invariably perform both above and below that target over the long-term timeframe. Prudent investors don’t lost sight of the fact that diversified, value-based investing means having to live through some periods of pain to maximize long-term success.

[1] Includes average performance data for approximately 420 endowment and foundation data as reported to Cambridge Associates as of June 30, 2017.  Not all clients elect to participate in quarterly surveys.  Returns are gross of Cambridge Associates’ fees, include assets for which Cambridge Associates may not provide investment advice, and are not reflective of the firm’s recommendations or portfolio advice.