Scientific Beta: How to manage US dominance in global equity portfolios
Scientific Beta released new research that examines how investors can mitigate US dominance in global equity benchmarks. The study 'Restoring International Diversification' employs a rigorous research framework to quantify the optimism embedded in current weights in US equities, and explores how investors can adopt more neutral views across regions.
Key findings:
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Global benchmarks embed an active bet on US outperformance: US equities now account for around 70% of global benchmark weight and close to 80% of its risk. Using reverse optimisation, we show that such a dominant place of US equities reflects a view that US equities will outperform the rest of the world by about 2% per year. Investing in a standard global benchmark is therefore not the absence of a view, it is adopting the market’s optimistic view on US outperformance by default.
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Even a modestly neutral view leads to substantial reallocation away from US equities. In current conditions, investors who believe that US equities will perform in line with the rest of the world, would have to reallocate more than 13% of their portfolio away from US equities, even when they are constrained to remain close to the global benchmark (tracking error budget of 3%). Note that this reallocation does not reflect a negative view on the performance of US equities. It reflects a neutral view that US stocks will deliver the same return levels as stocks from the rest of the world.
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We propose a practical tool to implement capital market assumptions across regions. Our framework allows investors to blend their return assumptions with the benchmark implied view to derive systematic regional allocations. Strikingly, even a positive view on US equities may require a reallocation away from US equities, if that view is less optimistic than the market’s. Investors who believe that US equities will outperform by 1% per year would need to shift about 5% of their portfolio away from US equities, even when they are constrained to stay close to the benchmark (3% tracking error constraint).
The research contributes to the ongoing debate about US dominance in global equity benchmarks by making the implicit return assumptions behind benchmark weights explicit, and by providing a systematic framework investors can use to adjust their regional allocation in line with their views.
'Investment professionals are at a loss when it comes to justifying regional allocations to their stakeholders', said Felix Goltz, Research Director at Scientific Beta. 'Our framework allows them to trace which view is reflected in different regional allocations. In current conditions, even a modestly neutral view justifies shifting 13% of the equity portfolio away from US equities.'
Highlights of results:
The figure below shows how much of the global equity portfolio would need to be shifted away from US equities for two different return assumptions: a neutral view and a mildly positive view on US outperformance.
