Standard & Poor's 500 Index (S&P 500), arguably the most widely accepted benchmark of large-cap U.S. stocks, is a float-weighted composite of the 500 companies that S&P's Index Selection Committee believes are the leaders in the United States' most important industry sectors. They are not only representative of the domestic U.S. stock market, but they are also a bellwether of the U.S. economy, since the S&P 500 is included in the Index of Leading Economic Indicators. Investors in these large-cap stocks typically seek the same advantages found by investing in the Russell 1000.
Morgan Stanley Capital International's (MSCI's) EAFE Index is the most widely accepted benchmark of foreign stocks in global markets outside North America because of its long history. It represents 85% of the market capitalization of the European, Australasian and Far Eastern stock markets, and it contains stocks from 21 developed markets outside the U.S. and Canada. Investors in EAFE stocks typically seek larger returns through opportunities outside North America.
Like the other strategies we have discussed, a strategy alternating between domestic U.S. and developed global market stocks can produce better risk-adjusted returns than a simple buy-and-hold strategy. Whereas before we used two-month-trailing returns, here we use one-year returns rebalanced annually (in January) because of the significant volatility between U.S. and developed global markets stocks.
This type of strategy correctly selected the group of stocks having superior returns in 12 of the 18 years studied, or 66.7% of the time. From January 1989 through October 2007, it produced an 11.5% annual return, which was 1.9% greater than the S&P 500 Index's 9.6% and 4.6% above the MSCI EAFE Index's 6.8% (Figure 1). Although it has a somewhat higher 14.2% annual standard deviation than the S&P 500's 13.6%, it has a lower volatility than the MSCI EAFE stocks' 15.9%. It provides superior excess return per unit of risk, as measured by its Sharpe ratio of 0.50. By comparison, the S&P 500's is 0.38 and the MSCI EAFE's 0.15.
This active S&P 500/MSCI EAFE strategy's maximum drawdown, -47.6%, recovers in 30 months. The S&P 500's maximum drawdown of -44.6% is slightly less, but the S&P 500 has yet to reach its prior high as of October 31, 2007. MSCI EAFE's drawdown of 48.0% recovers in 31 months (Figure 2).
The contrasting performances are shown in Figure 5, where the active strategy had a terminal value of $7.72 on October 31, 2007 for every initial $1.00 investment on January 31, 1989. The same investment in the S&P 500 stocks had a terminal value of $5.58 and the MSCI's dollar investment ended with $3.47.
In practice, this active strategy can easily be implemented using the iShares' S&P 500 Index Fund (IVV), which has an expense ratio of 0.09%, and iShares' MSCI EAFE Index Fund (EFA) which has an expense ratio of 0.35%. Both funds have small tracking errors relative to their respective funds.
Developed Versus Emerging Markets
The economic globalization that has spurred growth in the developed markets has also contributed to the rise of emerging markets. Yet the ebbing and flowing between developed and emerging markets frequently favor one over the other and can lead to profitable tactical opportunities.
MSCI's Emerging Markets Index is the most widely accepted benchmark for gauging the performance of emerging markets because it also has a long history. It is a float-weighted market capitalization index of geographically diverse companies in 26 countries: Argentina, Brazil, Chile, China, Columbia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Malaysia, Mexico, Morocco, Pakistan, Peru, the Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey and Venezuela. Investors in emerging markets stocks typically seek above-average capital appreciation over the long term and are willing to tolerate periods of significant volatility.
Hence, a strategy of alternately investing in developed and emerging markets can provide greater risk-adjusted returns than simply buying and holding those investments. This trend-following strategy invests in the outperforming asset class of last month and stays with or reverses into a profitable trend. Such a strategy correctly selected the group of stocks having superior returns in 138 of the 237 months tested, or 58.2% of the time. It produced a 17.8% annual return, which was 1.4% greater than MSCI's emerging markets' 16.3% and 10.0% higher than the EAFE's 7.8% for the period from January 1988 through October 2007 (Figure 1). Although the strategy has a significantly higher 20.3% annualized standard deviation than EAFE's 15.9%, it has 2.3% lower volatility than emerging markets stocks' standard deviation of 22.6%. Yet it provides superior excess return per unit of risk as measured by its Sharpe ratio of 0.65, compared with the MSCI Emerging Markets' 0.52 and the MSCI EAFE's 0.20.
This strategy's maximum drawdown of -42.4% is recovered in 29 months; MSCI's Emerging Markets' maximum drawdown of -56.0% takes 75 months to recover and MSCI EAFE's drawdown of 48.0% recovers in 31 months.
The significance of these differences is evident in Figure 6, where the strategy had a terminal value of $25.25 on October 31, 2007 for an initial $1.00 investment while MSCI's Emerging Markets' end value was $19.77 and the EAFE index's was $4.37.