Friday, March 26th, 2021

To See Ourselves as Others Do

One result of the slow rollout of vaccinations in Europe is that there are far fewer analysts calling for an overweight position in Eurozone equities relative to the US. We were never that convinced by the idea, preferring to concentrate on the UK and, until recently, Emerging Markets. Because of the way we structure our process, we pay almost no attention to valuations, no matter whether they are based on earnings, cashflow, assets or dividends. Hence, we were never seduced by the relative valuation argument.

There are two problems with the valuation argument. Firstly, there were – and still are – plenty of cheap stocks in America. This means that US investors can safely rotate away from growth into value, without crossing the Atlantic –Second, however much we say that investment is a global process, investors cannot easily transfer their equity management process from one region to another. What works in the US does not necessarily work in Europe. A significant shift in equity allocation from the US to Europe requires either a significant increase in in-house expertise or devolving a material part of the portfolio to external managers. These are strategic, not tactical, decisions and require a clear business rationale. This is where Europe, and in particular the Eurozone, has a major problem.

In one sentence, the problem is as follows. Over the last 10 years, there has not been any five-year period when diversifying part of an equity portfolio from the US into the Eurozone index would have provided a superior risk-adjusted return – let alone a superior total return – when compared with 100% exposure to the US. Worse still, there is no five-year period where any systematic approach to dynamic regional allocation would have met either of these two objectives. For the whole of the period, which includes data from 2005-2020, all US investors would have been better off they had had no exposure to the broad Eurozone equity index. This is a truly damning statistic.

The other two large equity regions, Japan and Asia ex Japan, each have one five-year period when a buy and hold strategy would have produced a better risk-adjusted return. If we look at dynamic allocation processes, Japan has produced a superior risk-adjusted return in 9 out of the10 periods, if we follow a risk-averse, mean-reversion strategy – i.e. buy Japan when it has underperformed, but only after demanding an excess return to compensate for higher volatility. In other words, the Japanese index has provided all of the tactical asset allocation opportunities that US investors are supposed to want from the Eurozone.

Eurozone supporters may argue that a 5-year test at the index level is too restrictive and that US investors want to gain exposure to individual sectors where the Eurozone has an advantage and to do so over a shorter time frame. It’s a fair point, so we performed exactly the same test for GICS Level 2 sub-sectors, and we cut the period from five to two years. There are only three sub-sectors (out of 17) where a buy and hold strategy, mixing US and Eurozone groups, would have provided a material improvement in risk-adjusted returns over the last 2 years. They are Utilities, Industrial Manufacturing and Energy. By contrast, there are nine sub-sectors in Asia ex Japan, and eight in Japan, which pass the same test. Approximately 50% of the Japanese and Asian equity markets have offered US investors opportunities for successful diversification, against less than 25% in the Eurozone. If US investors want to invest outside their home market, they are unlikely to come to Europe first.

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