Line Pointing

What Not To Put On Your New Year's Resolution List: Investment Strategy

Line Pointing

When we start the beginning of the year as we all customarily do, evaluating some of the things we neglected in the previous year, such as health and wellness, certain relationships, etc., and decide to reverse those trends this year, the one thing that should not be on the list of changes is your overall investment strategy.

It has been a very trying 1, 3, 5, 10, and maybe even 20 years for the globally diversified investor. Beyond the emotional roller coaster that the global markets took us through in the early 2000s and 2008-2009 periods, the investment principles that we base our investment strategy off of have not panned out as we would expect. In fact, over the last 10 years, an investor may have been better off doing the exact opposite, buying only the largest growth-oriented companies in the United States versus a globally diversified portfolio emphasizing the smaller and value oriented corners of the market. Over the 10-year period ending 12/2015, the IFA US Large Growth Index has delivered an annualized return of 8.47% per year versus 5.81% for IFA Index Portfolio 100 (our 100% stock portfolio). But if you were to ask us what changes we would make to our investment strategy, our answer would be, “absolutely nothing.”

Here is some healthy perspective about why we believe the path we have put investors on continues to be the best.

2015 In Review

2015 was really an ugly year all around in terms of investment performance. Although we can always point to the worse cases such as the Emerging Markets, most of the constituents of the S&P 500 and Dow Jones Industrial Average didn’t necessarily knock it out of the park either. The S&P 500 Index, which doesn’t take into account the return on dividends, lost 0.70% for the year, while a buy and hold investor of the S&P 500 Index Fund came out ahead with a modest 1.38% as reported by the IFA US Large Company Index, which is comprised of the DFA US Large Company Fund (DFUSX).

Further, the performance of the S&P 500 Index would have been much worse if it wasn’t for a handful of mega-cap growth stocks, which are currently being referred to as FANGS (Facebook, Amazon, Netflix, Google, and Starbucks, respectively). In their 2016 outlook report, a Goldman Sachs analyst points out that, “just five stocks with outsized returns accounted for the strong performance of the S&P 500; hundreds of others underperformed the broader market.”[1] The likelihood of being able to pick these winners before the fact is slim to none.

In fact, most investment professionals had a very difficult time picking out the needles in the haystack. According to an article from Fox Business, Morningstar analyzed actively managed mutual funds and gauged their performance against their respective benchmarks. The results: the vast majority of managers underperformed their respective benchmarks in 2015. The table below displays the results.

Percentage of Active Managers Who Underperformed Benchmark in 2015
1 Year (1/1/2015 to 12/31/2015)
Asset Class % Underperformed
US Large Cap Growth 66.74%
US Mid Cap Growth 56.56%
US Small Cap Growth 67.87%
US Large Cap Blend 73.15%
US Mid Cap Blend 87.63%
US Small Cap Blend 56.15%
US Large Cap Value 46.40%
US Mid Cap Value 50.75%
US Small Cap Value 32.61%

The funniest part of the article is actually the title: “Active Fund Managers Surprisingly Underperform in 2015.” We believe there is nothing surprising about these results. As we have demonstrated before in our SPIVA analyses, this trend is not unique to just 2015. You can see past articles here and here.

The bottom line is that there isn’t too much we can take away from 2015 that should direct action on our part for our investors. It is simply just a bad year all around. What many investors may find surprising is that the top-performing segment of the global stock market came from the smaller capitalized companies in the developed economies abroad.   

Global Diversification is Dead

While we can point to active management as an inferior alternative to buying and holding a portfolio of index funds, in general, we cannot escape the fact that the rest of the world has not been able to keep up with the United States over the last 5 years. So while our investors may not go out and buy the next hot active manager’s fund, they may be willing to abandon investments abroad and just stick with Warren Buffett’s thought of simply buying and holding the S&P 500 Index fund from Vanguard.[2] But before we decide to ignore almost 70% of the investable world, let’s bring some insight to the topic.

It is very, very important to note that performance comparisons between the US and abroad are sensitive to the time period being examined. For example, if you look at performance for the 20-year period from January 1996 to December 2015, you will see that most of the international indices have not kept pace with their domestic counterparts. From a risk and return standpoint, an investor would have been almost indifferent between investing in the S&P 500 Index and a globally diversified portfolio like the IFA Index Portfolio 100.

But what if we looked at the 15-year period from January 2001 to December 2015, what would we find? For that specific 15-year period, being globally diversified paid off tremendously. As you can see, most international developed and emerging market indices outperformed the S&P 500.

Likewise, if we were to look at the last 50-year period ending 12/31/2015, the results are very similar to the last 15 years. Again, the results are very time period specific. That is why it is important to have a very large sample size to draw any sort of conclusion about performance.

To give a more visual representation of performance comparisons over time, the chart below shows the year-to-year performance of the international equities as represented by the MSCI All Country World Index ex US and MSCI World ex US Index, and the S&P 500 from 1970 to 2015, which is the longest sample period available.

U.S. and International Stocks have Alternated as Global Market Performance Leaders
Trailing 12-month return differential, in percentage points

As you can see, the last 6-7 years has been pretty rough for the investable world outside of the United States, but it hasn’t always been the case. From 2001 to about 2007, we can say the exact opposite. Since 1970, the rest of the world and the US has alternated between outperforming each other over short time periods. Because we don’t want to rely on subjective opinion when making an investment decision, we ideally want to use statistical analysis. Based on the available data, we cannot draw the conclusion that the S&P 500 has had significant outperformance against its international counterpart.

The point is that while it may seem like an unfortunate case to be internationally diversified right now, it isn’t always the case. Global diversification allows us to gain exposure to other markets around the world. As we recently mentioned in another article, there is a whole other investable world beyond the US borders. Companies outside of the US make up approximately 70% of all investable companies and 50% of the global market capitalization. We can imagine that depending on factors such as currency movements, local inflation and monetary policy, fiscal policies implemented by local governments, innovation, political conflicts, and wars around the world will dictate where economic growth and value will manifest itself. We cannot know with certainty which part of the world will be the leader in performance so it is prudent to own everything.

It is also important to mention that international performance has been understated from the perspective of the US investor. Due to the strengthening of the dollar against most major international currencies, local returns are slightly deflated once we translate those gains back to the US dollar. For example, in the 4th quarter of 2015, large cap stocks in the international/developed markets returned 5.68% in local currency, but were deflated to 3.91% once those assets were translated back into US Dollars.[3] Although currency risk is very real for a globally diversified investor, it has historically not been as significant as the risk involved in purchasing equities.[4] We could use currency derivatives to hedge the risk of currency fluctuations, but the cost of doing so outweighs the benefit we are trying to seek. Think of it this way, using currency derivatives within equity portfolios is like trying to use an umbrella in the middle of a hurricane.

Small Cap & Value are Ideas of the Past

Beyond insignificant conclusions from 2015 and global diversification, there are also the style preferences that we implement within our portfolios: specifically, small-cap and value stocks. For the 10-year period ending December 31, 2015, US Large Cap stocks (as measured by the Russell 1000 Index) have outperformed US Small Cap stocks (as measured by the Russell 2000 Index) by approximately 0.60% per year. Similarly, US Growth stocks (as measured by the Russell 3000 Growth Index) have outperformed US Value stocks (as measured by the Russell 3000 Value Index) by approximately 2.38% per year. See table below.

Differences of Small Cap & Value
10 Year Period Ending 12/31/2015
Index Annualized Return
Russell 1000 Index 7.40%
Russell 2000 Index 6.80%
Difference 0.60%
Russell 3000 Growth Index 8.49%
Russell 3000 Value Index 6.11%
Difference 2.38%

It is important to remind investors that this underperformance in small cap and value stocks over the last 10-year period highlights the importance of understanding risk. If they were always positive, they wouldn’t be risky, and therefore we shouldn’t expect any extra return from these types of stocks.

There have been other times in history when the small cap and value premium did not reward investors for extended periods of time. There is never certainty around whether or not these premiums will pay-off, but that is still the expectation.

Looking over the last 88 years ending 12/31/2015, US Large Cap Growth stocks have outperformed US Small Value stocks almost 1 out of every 5 decades, based on monthly rolling returns. This just happens to be one of those decades. As you can see, although very unlikely, there have also been some 20-year periods when these risk premiums have not showed up.

Putting It All Together

While a globally diversified investor has not captured the best possible returns that the markets have offered over last 1, 3, 5, and 10-year periods, it does not insinuate that they should abandon their current investment strategy. Global diversification allows us to capture the benefits of markets around the world. There are times when the US outperforms the rest of the world and vice versa. Although small cap stocks and value stocks have not delivered over the last 10-year period, it shouldn’t be a nail in the coffin. Based on historical data, these types of events have happened once every 5 decades. It is always easy to look back after the fact and say, “well, we would have been better buying solely US Large Cap Growth stocks,” but it would be a mistake to extrapolate those results into the future. We take risk where we are expected to be compensated based on historical data and academic literature, and control the amount of risk through the use of bonds. This is not subjective opinion, but objective conclusions. Our recommendation would be to re-examine your risk capacity score to ensure that you have the proper amount of risk in your portfolio and go tackle the other resolutions you have set out for yourself this year.



[1] Ro, Sam. “The Stock Market’s Breadth is Unusually Shallow.” Business Insider. December 21, 2015.

[2] Mueller, Lucy. “The Best Investment Advice from Buffett and 11 Other Investors.” The Huffington Post. June 16, 2015. http://www.huffingtonpost.com/gobankingrates/the-best-investment-advice-from-buffett-and-11-other-investors_b_7596238.html

[3] Dimensional Fund Advisors, LP. “Quarterly Market Review, Q4 2015.” Dimensional Fund Advisors, LP. January 6, 2015.

[4] Fogdall, Jed & Gerard O’Reilly. “Currency Returns & Hedging Decision.” Dimensional Fund Advisors, LP. April 18, 2012.