Most defined contribution participants have minimal exposure to investments outside the U.S. and are not exposed to the long-term growth potential of some of the world’s most dynamic companies and industries. Just as defined benefit (DB) plans did in the 1990s, defined contribution (DC) plans should consider moving away from a largely U.S.-centric investment view to pursue potentially better absolute and risk-adjusted returns. Plan sponsors can encourage this by providing a balanced menu of investment choices that include international, global and even emerging markets equity options in their DC lineups.
Ideally, global portfolios should be considered for inclusion alongside domestic and international portfolios, as participants can have the potential to obtain better results with broader mandates than with the combination of separate components. Investing in a global portfolio can also help mitigate the likelihood of participants chasing returns between domestic and international markets and getting burned by cyclicality. Instead, professional judgment can shape the allocation based on a global perspective rather than one that is U.S.-centric.
Out of Line With Current Thinking
Defined contribution assets are predominantly invested in domestic equities, stable value and employer stock. As a result, many DC plan participants have minimal exposure to investments outside the United States. While the majority of the world’s equity market capitalization is outside the U.S. — and there appears to be a growing comfort level among participants to invest there — only 6% of DC assets are invested in non-U.S. stocks, according to Aon Hewitt. Another 1% is invested in dedicated emerging markets portfolios. 1 Additionally, a participant’s income and other forms of investment, such as real estate, are also likely to be denominated in U.S. dollars, resulting in a highly U.S.- centric base of assets.
Plan sponsors generally acknowledge that the allocation of DC assets is out of line with the size of overseas markets and the opportunities they represent. They also recognize participant allocations as not in sync with the current thinking and best practices of professionally managed defined benefit plans.
Aggregate Asset Mix of the Top 1,000 DC Plans as of September 30, 2011
Professionally managed DB plans on average allocate 17% to non-U.S. (developed market) equities — more than double that of the average individual plan participant. Separate allocations to global and emerging markets equities represent additional assets outside the U.S. This commitment is in the context of an even broader set of options available to institutional investors, including hedge funds and private equity. Institutional investors shifted significant DB assets overseas in the 1990s and have continued to do so.
DC participant assets in international equity:
DB assets in international equity:
Large-plan DB assets in international equity:
MSCI U.S. market cap as a percentage of MSCI All Country World:
MSCI EAFE market cap as a percentage of MSCI World:
Reviewing the Benefits of Broader Opportunities
Professional investors are more aware of the opportunities afforded by a broader investment universe. While the U.S. is still the largest economy in the world, it represents less than one-quarter of the global economy. Global portfolios can tap into wealth creation taking place outside U.S. borders. Global portfolios with the flexibility to invest in emerging markets have additional potential, as they can benefit from the dynamism of developing economies that are widely expected to expand much faster than developed ones for the foreseeable future.
From a bottom-up perspective, while U.S. companies are leaders in many areas, stocks outside the U.S. in a diverse group of industries such as chemicals, luxury goods, health care equipment, financial services and telecommunications have provided better returns over the past decade. Metals and mining is one example of an investment theme where participation through U.S. equities has been limited. Growing demand from China for key industrial commodities has led to a surge in profitability for metals and mining companies. Over 90% of the market capitalization of that industry is outside the U.S., with key players domiciled in Australia, Canada, Brazil and the United Kingdom.
Institutional investors have found that, over time, better risk-adjusted returns are possible through allocating a portion of assets overseas. Many DC participants could benefit by diversifying in a similar fashion. While correlations for equity markets across geographic regions have become higher, stocks outside the U.S. have continued to provide some diversification benefits. Many DC plans, however, to one degree or another have participant assets “diversified” across a group of highly correlated domestic equity offerings, due in part to overlapping stock ownership.
DC Domestic Equity Options Can Be Highly Correlated
The Benefits of Global Portfolios
Many plan sponsors and their consultants are beginning to rethink DC plan options with a view that increased participation in equities outside the U.S. would be beneficial. But how will DC plans get there? Every situation is different, and for some plans, adding international portfolios to complement their domestic options will make sense. For many plans, however, adding global portfolios should be considered for two important reasons.
The first reason is that a true, worldwide mandate seeks out the most attractive investment opportunities regardless of geography. Managers that have been given this broad mandate can choose investments from a wider universe on a real-time, flexible basis to assemble a portfolio of “best in world” companies, which will differ from an approach that combines portfolios of “best in region” companies.
For example, a manager might consider Siemens to be the best industrial company in the world while at the same time viewing General Electric as the best industrial company in the U.S. A truly global portfolio, therefore, might have a large position in Siemens, whereas the bolted-together portfolio might have a smaller position in each company. Even with our regionally focused portfolios, we allow some flexibility to invest outside the region in order to take advantage of this principle.
Being able to invest in the highest investment conviction on a worldwide basis can be powerful; it can lead to better results than stitching together regional portfolios. (This can be a double-edged sword, of course, magnifying good and bad investment decisions alike.) The stocks in American Funds global portfolios represent our strongest investment convictions on a worldwide basis. The weights of different regions, countries and industries in the portfolio are the result of forward-looking, bottom-up decisions.
The second reason is specific to DC plans. The introduction of more international choices effectively forces the asset allocation responsibility between domestic and international equities onto the participants. In many cases they may be ill-equipped to make that asset allocation decision and may be tempted to chase returns between regions.
The introduction of global equity strategies within these plans enables participants to hand such allocation decisions to professional money managers. Even for plans with investment-savvy participants and an existing suite of domestic and international portfolios, a global portfolio can be positioned as the swing asset allocator. In such a scenario, the sophisticated participant sets the strategic weighting by using separate domestic and international portfolios and leaves tactical moves to the professionally managed global portfolio.
Nearly all DC plans now offer an international equity option. But it is often a single option, competing with multiple U.S. equity choices. A stepped-up educational effort is part of the solution. Having a global equity option, however, could go a long way toward encouraging participants to increase their exposure to equities outside the U.S. This would be more in line with how professional investors allocate assets.