A 401k Menu for Today's Investing Reality
Cliff Dunteman of Francis Investment Counsel explains why more than a traditional mutual fund lineup is needed to help employees reach their retirement goals.
Only 8% of retirement plan assets are invested outside the United States. Cliff Dunteman, Vice President of Investment Consulting Services at Francis Investment Counsel, believes that is holding some investors back. "A modern 401k portfolio asset allocation must go beyond the traditional stocks, bonds, and cash allocation of the past and include non-US-based stock and bond funds." In the following Q&A, Mr. Dunteman outlines how "globalizing" a portfolio by including investments such as foreign bonds can help investors reduce risk and reach their retirement goals.
Q. What does "Globalizing your Portfolio" mean?
A. In our experience, 401k participants are long term investors looking to build wealth. Globalizing your portfolio is about increasing your portfolio's exposure to non-domestic companies and alternative asset classes in order to take advantage of structural shifts, both economically and politically, taking place on a global scale, resulting in faster economic growth occurring outside the United States.
Q. How is it different from a traditional asset allocation?
A. Traditionally, investors in the United States have tilted portfolios towards domestic holdings of equities and fixed income. This made sense in the 1970's when the U.S. economy represented 36% of the world's economic output and U.S. companies comprised 70% of the market capitalization of the world's publicly traded stocks.
However, today is different. Currently, the U.S. accounts for 23% of the world's economic output and U.S. companies represent 42.3% of the world's publicly traded stocks according to the MSCI All Country World Index.
Despite this change in world market capitalization, the average 401k investor's exposure to international funds is just 8% of assets according to a study recently conducted by Vanguard.
The benefit of diversifying in other asset classes is clear. For example, over the last 10 years, a combination of 60% U.S. stocks and 40% U.S. bonds provided you 60% less return for the amount of risk taken than a portfolio comprised of 25% U.S. Stocks, 30% U.S. Bonds, 25% International Stocks, 10% Emerging Market Bonds, and 10% Commodities.
Therefore, we believe investors should "globalize" their portfolios with more significant exposure to the world's fastest growing economies.
Q. What structural shifts and demographic trends are driving the need to "Globalize Your Portfolio"?
A. In advanced economies, such as the United States, Japan, and Western Europe, populations are aging but living longer. Due to prior social contracts offered to their populations and weak economic growth, governments are faced with difficult choices as a result of projected debt levels. This is forcing fiscal austerity at the local, state, and federal government levels. As everyone is tightening their belts, reducing spending and lowering debt, the outlook for economic growth is stunted. In fact, the IMF estimates U.S., Japan, and Euro area output will only grow at 1.8%, 2.3%, and 1.1% in 2012.
In contrast, Emerging Markets are growing at a much faster pace. The IMF estimates Brazil, Russia, India, and China will grow their economies in 2012 by 3.6%, 4.1%, 7.5%, and 9.0%. This is due to the liberalization of their economies, the subsequent growth of the middle class, and much healthier balance sheets. Today, estimates indicate there are 1.5 billion middle class consumers in emerging markets which will grow to 3.0 billion in 2030.
This 1.5 billion emerging middle class is now starting to consume. Mercedes Benz saw first half sales grow 60% in China year over year in 2011. Starbucks opened its 500th store in China this year. They plan to have 1,500 stores by 2015. Switzerland headquartered Nestle S.A., the world's largest food manufacturer, is growing at double digit rates in its Asia business. Apparently, emerging consumers like to drive fancy cars, drink expensive coffee, and indulge in chocolate just like we do in the United States.
These structural and demographic changes are clearly shifting the economic dynamics and are here to stay.
Q. Companies like Yum Brands and General Motors generate a significant amount of their revenue in other countries. Why not just get your "world exposure" from investing domestically?
A. That is correct. Today, companies comprising the S&P 500 generate approximately half their sales outside the U.S. "Globalizing Your Portfolio" is about expanding your opportunity set in both fixed income and equities. The fact is great companies with significant market share exist in local markets around the world and it can be difficult for a U.S. based employer to gain a foothold.
For example, Companhia de Bebidas das Americas-AmBev is a beverage company which produces, distributes and sells beer, carbonated soft drinks, and other non-alcoholic and non-carbonated soft drinks across 14 countries in the Americas. Within the beer market, Companhia maintains a 70% market share in Brazilian beer. It also holds licenses with Pepsi-Cola to distribute its products in Latin America. Another example is Markit, a chain-store equivalent of a Seven Eleven stores here in the U.S. It operates 4,500 convenience and "hyper-market" stores mainly in towns with populations under 500,000. This logistical advantage will make it hard for organizations like Wal-Mart to make an impact any time soon.
These are examples of companies with significant local knowledge giving them an advantage over U.S. companies.
Q. What asset classes are you suggesting investors consider?
A. We have identified five sub-sectors for investors to consider to diversify and potentially enhance their returns: Emerging Market Equities, Emerging Market Bonds, International Small Companies, Frontier Market Equities, and Hard Assets.
Q. Aren't you a little late to the Emerging Market theme?
A. Not really. According to Vanguard's study titled 2010 "How America Saves", only 20% of retirement plans offer a dedicated Emerging Market Equity product and only 11% of participants who are offered this category are utilizing it. In a more recent study, according to the Callan DC Index, retirement plans had less than .5% of plan assets invested in Emerging Market equity funds.
Q. What's the benefit of investing in Emerging Market Bonds?
A. We see three benefits relative to the typical 401k plan holding. First, the yields are higher. Today, a 10 year Treasury bond pays an investor just about 2% and an AA Corporate Bond approximately 3%. In contrast, the yield on the average Emerging Market Bond is over 6.0%.
Second, due to economic growth and higher yields, capital is flowing into Emerging Markets. This is driving the local currency higher against the U.S. dollar. This benefits the U.S. investor by enhancing returns when calculating performance in U.S. dollars.
Finally, Emerging Market economies have much better balance sheets. The total debt-to-GDP levels in emerging markets are much lower than in Europe, Japan, and the U.S. This will allow local governments to support their economies if the world economy turns south again.
Q. How are Frontier Market equities different than Emerging Market equities?
A. Frontier Markets are found in places like the Middle East and North Africa that have still to develop mature economies. And as we have seen this year's political unrest in this region, these economies still have a long way to go. However, there is clearly rapid development taking place and the thought is that these countries will become the next emerging markets. Additionally, China has turned to investing in Frontier Markets to meet their huge demand for natural resources. They are cooperating with local officials to build infrastructure in order to gain access to these mineral rich countries.
Frontier Markets have actually outperformed both the S&P 500 and EAFE indices over the last decade, and we wouldn't be surprised to see them outperform the Emerging Markets in the next ten years.
Q. What should an investor allocate toward these global asset classes?
A. It really depends on an investor's tolerance for fluctuation in her portfolio. While these represent important long term diversification, these asset classes come with the potential for significant short-term declines. In 2008, the last really difficult calendar year for stocks, the MSCI Emerging Market Equity, Dow Jones AIG Commodity Total Return Index, and JPMorgan EM Bond Index declined 53.2%, 35.7%, and 10.9% respectively. In 2011, these asset classes dropped 31.10%, 21.13%, and 5.78% at one point this year.
With that said, we believe an investor with a 10-year investment horizon, in a balanced portfolio should have at least half of the growth portion of her portfolio invested in non-U.S. equities and 10% of her fixed income portfolio invested in Emerging Market Bonds.
Francis Investment Counsel is a fee-only Registered Investment Advisor dedicated to providing independent investment consulting and employee education services to the qualified plan marketplace. The company delivers conflict-free investment advisory services to plan sponsors and also offers extensive education and individualized advice services to plan participants. Francis Investment Counsel has been named one of the "Most Successful Retirement Plan Advisors" by Plan Sponsor Magazine for five consecutive years.
Remember, this information is provided as general guidance. It is not provided as legal, tax or investment advice. Individual situations vary. Please be sure you consult with your tax, legal or financial advisor for more detailed information and advice.
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