Even when the international managers have outperformed, it’s usually been a result of the collective underweight of Japan by most investment managers during that market’s prolonged malaise in the late 1990s. The recent trend is that the traditional index is hard to top; only 7% of international equity large-cap core funds added value over the past five years (2002–2007) versus 53% in the previous five years (1997–2002). Certainly indexing appears to be a simple and effective approach to filling international equity allocations.
We believe cap-weighted indexes can be improved through the Fundamental Index methodology to deliver better returns providing the type of value added hoped for (but rarely delivered) by active managers. The RAFI Global ex-USA Index consists of the top 1,000 non-U.S. companies headquartered in developed countries. Just like the U.S. versions, these stocks are selected and weighted by fundamental metrics of firm size (cash flow, book value, dividends paid, and sales) rather than capitalization like traditional indexes. The result is a portfolio free from the return drag of overweighting overpriced stocks and underweighting underpriced stocks.
Our research shows that this simple and intuitive twist on the passive portfolio leads to terrific returns—the RAFI Global ex-USA achieves historical excess returns of 3.4% per year since 1984. Value added on the order of 3% annually would garner top decile peer group returns over intermediate to longer stretches. However, unlike the many top performing active portfolios with concentrated bets, it does so with great diversification—1,000 individual securities and broad exposure to most of the significant economic global sectors and countries. And for those concerned about tracking error relative to the cap-weighted EAFE benchmark, the RAFI Global ex USA generates a tracking error of only 4.4% for the 10 years ending June 30, 2007—a tame figure for those concerned with big deviations from the benchmark.
Expenses are always an important consideration for investors, and international investing is no different. Global equity research requires measurably more overhead—travel expenses, local offices, 24-hour trading platforms, multiple compliance and regulatory issues, and the like—than domestic research. These additional costs, of course, get passed on to the consumer. According to Morningstar, the average international equity mutual fund annual expense ratio was 1.46% in May 2007. Available Fundamental Index vehicles sell to the retail investor for approximately half this figure and sell for substantially less to institutional-size mandates. Also according to Morningstar, the average international fund turned its portfolio over at an annual rate of 79% over the past five years versus the RAFI Global ex-USA long-term historical turnover of 13%.
So, does the RAFI concept fulfill the primary diversification goal of investors with international equity allocations? The answer is yes. It provides high correlation with traditional cap-weighted EAFE indexes and lower correlation with traditional U.S. indexes. From 1984 through March 31, 2007, the RAFI Global ex-USA posted a correlation of 0.67 with the S&P 500, which is comparable to the correlation for EAFE with the S&P 500 of 0.69. Furthermore, the RAFI Global ex-USA is less volatile; its annual standard deviation since 1984 has been 17.3% compared with 18.8% for EAFE and 15.6% for the S&P 500.
By providing ample diversification and reasonable similarity to traditional indexes, the Fundamental Index portfolio is a sensible, core international solution that can serve both passive and actively inclined investors.