Based on my post Monday, I decided to audit the performance of my retirement funds for the last 10 years. I figured I should do this despite the fact that I have been hammering home the point that you should establish a diversified and conservative long term strategy for your retirement funds, stick to it, and never look back.
There is always a downside for stocks, but I don’t get too aggressive with my retirement funds because the downside of being too aggressive is too great of a risk: the risk of no retirement, or worse yet, being physically unable to work and broke in retirement.
Where I Keep My Savings
Most of my 401k and traditional IRA, which I rolled over from a previous employer, are in 1 fund: a Vanguard Target Index Retirement Fund. About 80% of my retirement savings are in this fund. It’s very simple. It has a mix of 90% stocks and 10% bonds until there is 25 years left until the retirement date, then it begins to slowly adjust to a mix of 50% stocks by the target year and then will continue down to 30% stocks 7 years after the target date. There is a diversified mix of domestic US stocks, international stocks, US bonds and international bonds. The “glide path” of the 90% stock allocation to 30% looks like this.
Source: Vanguard
In addition to this fund, I also hold positions in a small cap US index and a small cap international index. This is what I split my Roth IRA investments between. My rationale for holding these two funds are that I have lot of risk tolerance and I am willing to take the risk and volatility of small caps to compliment the conservative target date fund in the long term. Small cap funds tend to have higher returns over the long term but they are also more volatile than large cap indexes like the S&P 500.
Comparing My Returns
Given that I am still so heavily weighted towards stocks, I would assume that my performance for the last 10 years would lag the S&P 500 a bit but not too much. I was disappointed to see the below.
Source: Vanguard
I could be sitting on about a quarter more money right now if I had just invested in the boring old S&P 500. Since I am a glutton for punishment, and I know tech stocks have been the ones lifting the market in this current rally, I decided see what it would look like if I added the Nasdaq to the chart above.
Source: Vanguard
Even worse, I could have been sitting on almost double of what I currently have if I had invested in the Nasdaq index instead. Instead of getting upset and just wallowing in self pity of the money that never was, I decided to look into why my fund wasn’t doing as well as the US market and there was a little case for optimism.
The Breakdown
To understand the underperformance, we need to look into what the fund invests in currently.
Source: Vanguard
I know the Total Stock Market Index quite well since I used to hold it in my brokerage account. It is simply an index of all the stocks traded on the New York Stock Exchange which is about 5,000 stocks last time I checked. So no worries here.
The 10% in bonds I know isn’t going to match the return of the S&P 500 so it was a given that bonds would drag down the returns a bit during an equities rally. When we look into the International Stock Index however, I am not as familiar on what it invests in, so I decided to find out. The breakdown by region is like this:
Source: Vanguard
So maybe the underperformance compared to the US lies in on of these regions.
Europe and Asia Pacific make up almost 70% of this part of the fund and they have surely underperformed the US market. When we look at these markets broken out versus the international index though, it seems they still beat it.
Source: Vanguard
The majority of the rest of the portfolio is made up of emerging markets, and here is where we may see the culprit when looking at the returns versus the international index.
Source: Vanguard
It seems that emerging markets have been an important part of dragging down growth in my overall portfolio in addition to the slow growth stories in places like Japan and the EU.
Keep in mind that there is currency risk here as well. When the dollar strengthens, it weakens returns from other markets, even when they are doing well. This is especially true in emerging markets as pointed out by Lazard.
Source: Lazard
How Did it Come to This?
The theory used to go: if you are young and aggressive, you have to get into emerging market stocks because that’s where the growth is over the long term. Over the past 10 years though, this just hasn’t been the case. Defying all conventional wisdom, large cap US stocks, mostly the tech firms, have dominated returns and pushed the US market to a much higher 10 year return than in any emerging market.
So what happened?
- The Trade War – Its a bit of a cop out to name this as a cause since Trump has only been in power since 2017, but you can’t deny that it is hurting open export oriented economies. In addition, the US sets the culture agenda for much of the world and his election touched off a backlash that has seen right wing or populist candidates elected in Europe, Asia and Latin America. This has substantially diminished the outlook for international trade, something that many export oriented open economies rely on, which can explain some of the underperformance.
- Corruption – Emerging markets have been rocked by a number of high profile corruption scandals in the past decade. From the Lava Jato scandal that toppled entire governments in Latin America to “state capture” by the Gupta brothers in South Africa, corruption has played a big part in scaring away international capital and dragging many emerging economies into recession.
- Red Tape – Too many rules, too many taxes. Many are surprised to learn that Brazil is consistently ranked as one of the most difficult places to start a business in the world, it falls in the company of weak African states in terms of ease of doing business. Arcane labor laws and pension requirements make starting a business a potential mine field bureaucratic fines and levies. Incoherent tax rules and rates in emerging countries that are higher than in rich countries drag on the appeal of these markets for foreign investment.
- No Tech – Outside if companies like Alibaba and Tencent in China, where are the big tech plays like those that exist in the US? Due to government censorship and control, China has essentially had to develop its own big tech players independent of Facebook and Google which has offered fantastic returns but where are the rivals in other countries? This helps explain the outperformance of the US markets again, the internet companies get to take advantage of scale and a global reach to be first movers and innovators not just in the US but all over the globe, the world has to do a better job of catching up.
The Case for Optimism
Despite all this, there is a strong case for optimism. The US seems to be pulling the world along for now but this will not always be the case. Tech companies are coming under increasing scrutiny, not just from the US government but the EU as well. Just look at the backlash to Libra, which I think in and of itself is a noble and great idea to try to engage more of the world in the global economy, but the timing is not right. Facebook is in the midst of taking heat for potentially tilting the US election and now it looks as if it’s coming for governments currency as well.
Big tech doesn’t seem to have a grasp on the huge regulatory risk it is taking at this point, further restrictions and continued scandals could drag down future returns.
On the other hand, in the long run emerging markets are going to start to see the results of a demography dividend, which the rich world will not experience. More workers, new ideas and new companies we don’t even know about yet are just around the corner in these places.
In addition, countries have spent much of this down time working on reforms, India lowered its corporate tax rate by a third, Brazil looks likely to pass a sweeping pension reform and South Africa has taken back its institutions from rent seekers. In flatiron is stable, debt is low and economies are still growing.
Emerging markets are cheap as well. The P/E of the last 12 months (P/E LTM) started this year out at a 32% discount to the S&P 500 and profits are expected to rise faster than the S&P in 2020.
Source: Lazard
Indeed, stories are even starting to break in large bullish options bets on emerging markets moving into next year. Even Russia, yes Russia is one of the best performing indexes at around a 30% return this year as companies have been pushed to give more money back to shareholders.
Source: Yahoo Finance
It makes sense, no market segment really dominates more than 10 years and most markets don’t remain in the doldrums for more than 10 years either. It’s been a tough post crisis for emerging markets and international stocks in general. When things look the worst, that is usually the time to jump in so you can buy low. The tech rally was nice but I won’t be chasing yesterday’s returns, I plan on staying with my allocation and sticking to my guns with the knowledge that underperforming sectors eventually switch on and outperform and outperforming sectors will see their returns come back down to earth. It’s the law of averages for the stock market and emerging markets are overdue for an upturn.
Update:
After I wrote this, I came across a chart on Bloomberg that really shows how the strong dollar has really been at the heart of emerging market underperformance. In the long run as emerging economies catch up, their currencies will actually appreciate against the dollar so it reinforces the point that emerging market stocks, and bonds for that matter, are on sale right now.
Source: Bloomberg