Derek Tharp’s clients at Mote Wealth Management might be in for a surprise at first, when they learn that more than half their portfolios are devoted to international diversification. That’s because at Mote Wealth, global market cap is a determining factor in assembling a portfolio, and according to Tharp, the U.S. is not the dominant market cap.
“Many clients are initially surprised by this amount of international diversification, but once they understand the approach they are very open to the strategy,” Tharp said. “We also use an excellent graphic that maps out the world’s economies based on market capitalization, which is very helpful in comparing how large various equity markets are.”
Such diversification has always been a part of the portfolios at Mote Wealth, Tharp said, “to make sure that we were trying to maximize the returns while minimizing the risk. That meant finding investments all around the world, to spread out the risk and not be too concentrated in one area.”
Currently the U.S. not only does not dominate, but it makes up only about 48.5% of the global market cap; as a result, that’s its position in client portfolios as well. The firm doesn’t favor or seek out individual regions, either, Tharp said, because the strategy is passive. Therefore, the U.K., for instance, makes up approximately 7% of the weighting, with emerging markets accounting for about 13% and providing exposure to such countries as China, India, and Brazil.
“If a place like Australia takes off, we want to be there to capture that,” Tharp said. “When you look at places a little more poised for growth, like emerging markets, [you want to be there too]. We do stay away from frontier markets, because they’re such a small portion of the global market cap and because we don’t feel there’s a cost-effective way to reach them.” The firm uses mutual funds and bond funds, both U.S. and international, but “nothing outside of that,” he said.
“Initially we see a lot of people who are very overinvested in the U.S. They’re not fully diversifying in that respect, and when they come and see what we’re proposing, at first it’s a big change,” Tharp said. “But we explain that they’re concentrating a lot of their capital through the stock market, their employer, and government programs in the U.S., so to try to spread out some of that risk really makes sense.”
That brings up an interesting point that he expanded on: “Many advisors embrace the concept of not overinvesting in an individual’s employer, but they don’t apply the same principles to geographical diversification. This is concerning because there are potential risks for a U.S. investor that are correlated with the U.S. equity market. For instance, entitlement programs are dependent on tax revenues and tax revenues are dependent on overall U.S. economic health. In the event of a severe U.S. economic downturn, investors not only see the values of their portfolios fall, but they face a greater risk of unemployment, cuts to entitlement programs [such as Social Security and Medicare, but also any other governmental assistance programs that rely on tax revenues], and tax increases.”
Another area of risk that can be overlooked when deciding how much to allocate to ex-U.S. investments is the allocation within a client’s pension. Many U.S. pension funds are over weighted to U.S. securities, according to Tharp. “While in theory the investment risk of a pension lies with the employer, a severe U.S. economic downturn could push a pension plan towards insolvency. Even if the pension plan is insured by the PBGC [Pension Benefit Guaranty Corp.], plan participants could see reductions in benefits under the PBGC’s rules.” Diversification away from the U.S. could help to reduce that risk.
“I do think you see a lot of advisors who have a home bias to the U.S., and I think it’s worth it to at least address it. There could be good reasons to have a home bias; some investors may want to overinvest in the U.S. as kind of a patriotic thing, and that’s fine,” Tharp said. “But they should understand the risk of concentrating in any one economy [on the chance] that it will outperform. As long as people understand that risk, it’s fine, but there’s no academically sound reason to take that risk. If you look at recent history, it’s been the U.S. portion that has been outperforming the rest of the world, so it’s been a successful region of late, but we want to remind our clients that it isn’t necessarily the case,” he said.