Issue Briefs

Investment opportunities exist all around the globe.

Across more than 40 countries, there are over 15,000 publicly traded companies.^[1] If you listen to the news, however, some countries may seem like better places to invest than others based on how their economies and stock markets are doing at the time. Fluctuations in performance from year to year only add to the complexity, providing little useful information about future returns.

Daunted by the prospects of sorting it out, some investors look to the place they know best—their home market. There can be good reasons, such as tax benefits, for prioritizing an investment close to home, but too much home bias could mean underweighting or missing out on part of the investment universe.

Australia, for example, represents 2% of the global equity market. An Australian who aims to build a global equity portfolio may have cause for investing a greater amount at home. However, this would come with the tradeoff of reduced investment in other countries. The same is true for a Japanese investor, whose home country represents 8% of the global equity market. Even the US equity market—the world’s largest by far—is only about half of the global opportunity set.

Fortunately, no one needs to be an expert in every region to benefit from the opportunities those regions present. Equity markets process information continuously, leveraging knowledge from millions of buyers and sellers each day as they set security prices. Investors can trust market prices to provide an up-to-the-minute snapshot of global investment opportunities.

Because prices do such a good job incorporating information about securities in every market, they also offer the best prediction of future prospects. No sensible story or compelling empirical research suggests investors can consistently outguess those prices and pick winning countries. A well-diversified global portfolio can help capture the returns of markets around the world and deliver more reliable outcomes over time.

Reading the checkerboard

The tables in Exhibit 1 illustrate 20 years of annual equity returns for developed and emerging markets. Each color represents a different country. Each column is sorted top down, from the highest-performing country to the lowest.

Taken together, these tables powerfully demonstrate the randomness of global equity returns. In either table, pick a color in the first column and follow it through to the right. Does any country seem to follow a pattern that gives clues about its future performance?

Exhibit 1: Annual Returns

1999–2018

Past performance is no guarantee of future results. MSCI country indices (net dividends) for each country presented. MSCI data © MSCI 2019, all rights reserved.

Consider the performance of the US and Denmark, shown in Exhibit 2. Is it immediately clear which country had the higher return over the past two decades?

Denmark, in fact, was the best performer among all developed markets, with an annualized return of 9.1%. Surprisingly perhaps, Denmark had the best calendar year return only once, in 2015. The US, despite some strong returns in the last several years, placed ninth overall with an annualized return of 4.9%. Bear in mind, Denmark represents less than 1% of the global market cap available to investors.

Exhibit 2: Who Performed Better over the 20-Year Period?

Past performance is no guarantee of future results. MSCI country indices (net dividends) for each country presented. MSCI data © MSCI 2019, all rights reserved.

From first to worst

Denmark also provides an example of the unpredictability in short-term results. After posting the highest developed market return in 2015, Denmark had the lowest return in 2016. Countries have also moved in the opposite direction, from worst to first, in consecutive years. In 2000, New Zealand had the lowest return among developed markets followed by the highest return in both 2001 and 2002. In emerging markets, Hungary and Russia went from the bottom two performers in 2014 to the top two performers in 2015.

Going to extremes

In a single year, the difference between the return of the highest-performing country and the lowest can be dramatic, as shown in Exhibit 3. Among developed markets over the last 20 years, the difference between the best and worst performers has ranged from a low of 24% in 2018 to as much as 81% in 2009. The differences in emerging markets are even more pronounced, ranging from 39% in 2013 to 160% in 2005. In fact, the difference in emerging markets has exceeded 100% in several years.

These extreme differences in outcomes, combined with the examples of countries that experienced sharp reversals in their return rankings, highlight the risk of trying to predict future returns by looking at the past and emphasize the importance of diversification across countries.

Exhibit 3: Return Differences

Past performance is no guarantee of future results. MSCI country indices (net dividends) for each country presented. MSCI data © MSCI 2019, all rights reserved. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Now, the good news

This evidence of the randomness in global equity returns, though, is not bad news for investors. Rather than trying to guess which country is going to outperform when, investors committed to a well-structured, globally diversified portfolio are better positioned to capture the performance of the global markets, where and when it occurs.

Over the last 20 years, every dollar invested in a globally diversified strategy, shown by the Dimensional Global Market Index in Exhibit 4, nearly tripled.

A globally diversified approach can deliver more reliable outcomes over time with less volatility than investing in individual countries. This can help investors stay on track, through all kinds of markets, toward their long-term goals.

Exhibit 4: Growth of $1
1999–2018

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Data presented in the Growth of $1 chart is hypothetical and assumes reinvestment of income and no transaction costs or taxes. The charts are for illustrative purposes only and are not indicative of any investment. See disclosures for more information on the Dimensional Global Market Index.

Source: Dimensional Fund Advisors LP.

DIMENSIONAL GLOBAL MARKET INDEX

January 1990–present: Compiled by Dimensional from Bloomberg securities data. Market cap-weighted index of all securities in the eligible markets. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices—each one reconstituted once a year at the end of each quarter of the year. Maximum index weight of any one company is capped at 5%. Countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK, and the US. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate the risk of market loss.

International investing involves special risks, such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

1. . Number of countries and publicly traded companies data provided by Bloomberg. ↑

“I have found that the importance of having an investment philosophy—one that is robust and that you can stick with— cannot be overstated.”

—David Booth

The US stock market has delivered an average annual return of around 10% since 1926.^[1] But short-term results may vary, and in any given period stock returns can be positive, negative, or flat. When setting expectations, it’s helpful to see the range of outcomes experienced by investors historically. For example, how often have the stock market’s annual returns actually aligned with its long-term average?

Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 Index had a return within this range in only six of the past 93 calendar years. In most years, the index’s return was outside of the range—often above or below by a wide margin—with no obvious pattern. For investors, the data highlight the importance of looking beyond average returns and being aware of the range of potential outcomes.

Exhibit 1: S&P 500 Index Annual Returns

1926–2018

In US dollars. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.

TUNING IN TO DIFFERENT FREQUENCIES

Despite the year-to-year volatility, investors can potentially increase their chances of having a positive outcome by maintaining a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the US market. The data show that, while positive performance is never assured, investors’ odds improve over longer time horizons.

Exhibit 2: Frequency of Positive Returns in the S&P 500 Index

Overlapping Periods: 1926–2018

In US dollars. From January 1926–December 2018, there are 997 overlapping 10-year periods, 1,057 overlapping 5-year periods, and 1,105 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.

Conclusion

While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. By thoughtfully considering these and other issues, investors may be better prepared to stay focused on their long-term goals during different market environments.

Source: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

1. As measured by the S&P 500 Index from 1926–2018. ↑

Over the last several years, index funds have received increased attention from investors and the financial media.

Some have even made claims that the increased usage of index funds may be distorting market prices. For many, this argument hinges on the premise that indexing reduces the efficacy of price discovery. If index funds are becoming increasingly popular and investors are “blindly” buying an index’s underlying holdings, sufficient price discovery may not be happening in the market. But should the rise of index funds be a cause of concern for investors? Using data and reasoning, we can examine this assertion and help investors understand that markets continue to work, and investors can still rely on market prices despite the increased prevalence of indexing.

MANY BUYERS AND SELLERS

While the popularity of indexing has been increasing over time, index fund investors still make up a relatively small percentage of overall investors. For example, data from the Investment Company Institute^[1] shows that as of December 2017, 35% of total net assets in US mutual funds and ETFs were held by index funds, compared to 15% in December of 2007. Nevertheless, the majority of total fund assets (65%) were still managed by active mutual funds in 2017. As a percentage of total market value, index-based mutual funds and ETFs also remain relatively small. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total US stock market capitalization in 2017.

Exhibit 1: Investor Breakdown in the US Stock Market as a Percentage of Total US Stock Market Capitalization

All totals may not equal 100% due to rounding. Sourced from the 2018 ICI Fact Book: ici.org/pdf/2018_factbook.pdf

In this context, it should also be noted that many investors use nominally passive vehicles, such as ETFs, to engage in traditionally active trading. For example, while both a value index ETF and growth index ETF may be classified as index investments, investors may actively trade between these funds based on short-term expectations, needs, circumstances, or for other reasons. In fact, several index ETFs regularly rank among the most actively traded securities in the market.

Beyond mutual funds, there are many other participants in financial markets, including individual security buyers and sellers, such as actively managed pension funds, hedge funds, and insurance companies, just to name a few. Security prices reflect the viewpoints of all these investors, not just the population of mutual funds.

As Professors Eugene Fama and Kenneth French point out in their blog post titled “Q&A: What if Everybody Indexed?”, the impact of an increase in indexed assets also depends to some extent on which market participants switch to indexing:

“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”^[2]

WHAT’S THE VOLUME?

Trade volume data are another place to look for evidence of well-functioning markets. Exhibit 2 shows that despite the increased prevalence of index funds, annual equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets continue to facilitate price discovery at a large scale.

Exhibit 2: Annual Global Equity Market Trading Volume, 2007–2018

In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Besides secondary market trading, there are also other paths to price discovery through which new information can get incorporated into market prices. For example, companies themselves can impact prices by issuing stock and repurchasing shares. In 2018 alone, there were 1,633 initial public offerings, 3,492 seasoned equity offerings, and 4,148 buybacks around the world.³ The derivatives markets also help incorporate new information into market prices as the prices of those financial instruments are linked to the prices of underlying equities and bonds. On an average day in 2018, market participants traded over 1.5 million options contracts and $225 billion worth of equity futures.^[3]

HYPOTHESIS IN PRACTICE

Even though the historical empirical evidence suggests that the rise of indexing is unlikely to distort market prices, let’s consider the counterargument that the rise of indexing does distort markets and in turn causes prices to become less reliable. In this scenario, wouldn’t one expect stock-picking managers attempting to capture mispricing to have an increased rate of success over time?

Exhibit 3 shows little evidence that this has been the case. This chart shows the percentage of active managers that survive and beat their benchmarks over rolling three-year periods. These data show that there is no strong evidence of a link between the percentage of equity mutual fund assets in index funds and the percentage of active funds outperforming benchmark indices.

Exhibit 3: Active Manager Performance Has Not Improved
Percentage of Non-Index Equity Funds Outperforming for Three-Year Rolling Period, 2004–2018

Equity mutual fund outperformance percentages are shown for the three-year periods ending December 31 of each year, 2004–2018. Each sample includes equity funds available at the beginning of the three-year period. Outperformers are funds with return observations for every month of the three-year period whose cumulative net return over the period exceeded that of their respective Morningstar category index as of the start of the period. US-domiciled non-Dimensional mutual fund data is from Morningstar. Dimensional fund data provided by the fund accountant. Past performance is no guarantee of future results. For more methodology details, see the latest Mutual Fund Landscape brochure.

Lastly, in a world where index funds bias prices, we should expect to see evidence of such an impact across an index fund’s holdings. In other words, there should be more uniformity in the returns for securities within the same index as inflows drive prices up uniformly (and outflows drive prices down). Taking the S&P 500 Index as an example, however, we see that this has not been the case. The S&P 500 is a widely tracked index with over $9.9 trillion USD indexed or benchmarked to the index and with indexed assets comprising approximately $3.4 trillion USD of this total.^[4] Exhibit 4 shows that in 2008, a year of large net outflows and an index return of –37.0%, the constituent returns ranged from 39% to –97%. This exhibit also shows that in 2017, a year of large net inflows and a positive index return of 21.8%, the constituent returns ranged from 133.7% to –50.3%. We would also expect that constituents with similar weighting in traditional market cap-weighted indices would have similar returns. In 2017, Amazon and General Electric returned 56.0% and –42.9%, respectively, despite each accounting for approximately 1.5% of the S&P 500 Index.

Exhibit 4: Range of S&P 500 Index Constituent Returns

Upper chart includes 2008 total returns for constituent securities in the S&P 500 Index as of December 31, 2007. Lower chart includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

CONCLUSION

Despite the increased popularity of index-based approaches, the data continue to support the idea that markets are working. Annual trading volume continues to be in line with prior years, indicating that market participant transactions are still driving price discovery. The majority of active mutual fund managers continue to underperform, suggesting that the rise of indexing has not made it easier to outguess market prices. Prices and returns of individual holdings within indices are not moving in lockstep with asset flows into index funds. Lastly, while naysayers will likely continue to point to indexing as a hidden danger in the market, it is important that investors keep in mind that index funds are still a small percentage of the diverse array of investor types. Investors can take comfort in knowing that markets are still functioning; willing buyers and sellers continue to meet and agree upon prices at which they desire to transact. It is also important to remember that while indexing has been a great financial innovation for many, it is only one solution in a large universe of different investment options.

GLOSSARY

Derivative: A financial instrument whose value is based on an underlying asset or security.

Options Contract: An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price.

Futures: A financial contract obligating the buyer to purchase an asset or a seller to sell an asset at a predetermined future time and price.

1. ici.org/pdf/2018_factbook.pdf ↑
2. famafrench.dimensional.com/questions-answers/qa-what-if-everybody-indexed.aspx ↑
3. Options, futures, and corporate action data are from Bloomberg LP. Options contact volume is the sum of the 2018 daily average put and call volume of options on the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, and MSCI Emerging Markets Index. Equity futures volume is equal to total 2018 futures volume traded divided by 252, where annual volume traded is estimated as the sum of monthly volume times month-end contract value for S&P 500 Mini futures, Russell 2000 Mini futures, MSCI EAFE Mini futures, and MSCI Emerging Markets Mini futures. IPO, seasoned equity offering, and share repurchase data are based on Bloomberg corporate actions data and include countries that are eligible for Dimensional investment. ↑
4. Source: S&P Dow Jones. ↑