Human nature is a funny thing. We tend to forget history quickly and then project the current situation into the future. The only thing that is truly constant in our world is change, yet most of us do not deal well with change. We fail to recognize that it has happened and then we fail to appreciate that it will keep on happening.
This is true in many aspects of life, but I am thinking about the area I know most about, investing. The “Trump Rally,” which interestingly began in the third quarter of last year when Trump’s opponent was still well ahead in the polls (see what I mean about short memories), seems to be taking a rest. This rally has been strong and it has marked a change of course from the last several years.
We have been in a market where the only assets that were rising in value were the stocks of large U.S.-based companies. Even among those, it was only a select few. In such an environment, a few things happen. First, active managers who tend to believe in being diversified do not do as well. Secondly, international investments do not do so well. The last time we went through a period like this was in the late 1990’s as what later became known as the tech bubble was being inflated. When that bubble popped, we entered a decade where the only money to be made in investments was overseas. We also entered a period in which active managers thrived.
It is funny how that history gets forgotten. A few times in the last several weeks I have had someone tell me that international investments have lagged for 30 years. I’m not sure where this came from; it could have been an article that I missed, but multiple people have said the same thing. I have been working for most of that time and this was not my recollection, so I researched it.
I researched by going to the international funds we use with our various clients. Some of them do not go that far back, but two of them have 29-year track records. I figured that was close enough. The two funds are the American Funds EuroPacific Growth Fund and the Harbor International Fund.
I first compared the international benchmark, which is the MSCI EAFE index, with the S&P 500. Over the last 29 years the international index has indeed lagged. The S&P 500 has an average annual return of 10.33% while the MSCI EAFE has an average annual return of 5.35%. That is a lot of underperformance. The story changes a little when we look at the funds. EuroPacific has an average annual return of 9.27%, and Harbor’s average annual return is 10.42%.
There are no tricks here. I did not run any kind of search for the best international funds. I simply looked at the funds that we actually use with our clients which had track records going back that far. Two things happen: First, international investing looks a lot better when using actual international investments. Secondly, this puts into perspective the whole active vs. passive argument. We live in a world today where pundits love to abuse active managers and say crazy things like, “Why would you pay 0.50% more to be in an actively managed fund when active managers ‘never’ beat the index?”
These two funds beat their index by 3.92% and 5.07% compounded every year for 29 years. Remember that is net of their expenses, as mutual fund returns are always reported net of their expense ratio. If one had chosen an index option in this category the return that investor would have received is 5.35% minus that oh-so-reasonable expense ratio. Does that really sound prudent?
All manager styles will go in and out of favor over time. Harbor has been struggling as of late. But history tells us that whenever a majority of top-tier active managers underperform their index, it is because there is something wrong in the market. For international investors over the last thirty years there have been many market problems: Japan, pretty much the whole time. The Asian contagion of the late 1990’s. The Russian financial crisis. The war in Serbia. The European financial crisis. The index went through them all. Active managers didn’t, and that equals a 4 to 5 percent excess return annualized.
Will that happen again over the next thirty years? I don’t know, but my guess is something similar will, because as Mark Twain is reputed to have said, “History doesn’t repeat itself, but it sure does rhyme.” I hope I’m still here and get to see it. In the meantime, we will keep doing what has proven to work over time, even if everyone else has forgotten.
Chuck Osborne, CFA