Investment Focus

Study Abroad A Case for Active Non-US Equities There’s No Place Like Home? The “Home Bias” PuzzleMost US investors today hold the majority of their equities in domestic companies. Reducing this “home bias” to the United States may create an opportunity that can benefit investor portfolios. Non-US equities can be strong diversifiers, as they have posted relatively low correlations with each other and with US stocks. Non-US equities markets have outperformed US equities for most of the past two decades, and include some of the most well-known brands and successful companies in the world. The non-US equity market is also generally less covered than the United States, which we believe may create additional opportunities for active managers.

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When it comes to investing, people often prefer to stay close to home. This reflects a home bias—the tendency for investors to overweight their investment portfolios to their own country relative to global benchmarks. In the United States, investors typically hold most of their assets in US securities, despite extensive opportunities abroad. In fact, while the United States accounts for little more than half the market cap of the MSCI ACW All Cap Index and less than a quarter of global GDP, almost three-quarters of the equity assets owned by US investors today are US stocks. This overweight to US securities has been especially consistent over the past several years (Exhibit 1).

Many reasons have been cited for what academics call the “home bias puzzle,”1 including familiarity with US markets and companies, cur-rency risk, and the higher costs associated with non-US ordinary shares. We believe, however, that there are many reasons to reduce home bias:

• Enhanced Diversification

– Low correlations among regions

– Non-US equities have outperformed US equities many times over the past 20 years

• A World of Opportunities

– Non-US stocks compose half of global market cap and have some of the strongest brands

– GDP growth is not necessarily market growth

• Going Abroad: Potential for Outperformance

– Active managers are more effective in non-US markets

– Stocks are currently cheaper outside the United States

Enhanced DiversificationPortfolios with a home bias in their equity allocations are missing out on potential diversification benefits. Over the past two decades, non-US equity performance has generated relatively low correlations with US stocks (Exhibit 2).

Investors who shun non-US equities may also miss out on the chance to diversify their returns across other developed and emerging markets. Over the past two decades, both developed and emerging markets

Exhibit 1US Investors Still Hold Most of Their Equities in US Companies

0

25

50

75

100

Non-US EquityUS Equity

(%)

2015201420132012201120102009

As of 31 December 2015

Source: Strategic Insights

Exhibit 2Non-US Equities Can Offer Low Correlations to US Stocks

World Equities

World Equities ex-US

Non-US Developed

Markets EuropeEmerging Markets

United States Japan

United Kingdom Germany Australia Italy

World Equities 1.00

World Equities ex-US 0.96 1.00

Non-US Developed Markets 0.95 1.00 1.00

Europe 0.92 0.93 0.92 1.00

Emerging Markets 0.76 0.75 0.73 0.72 1.00

United States 0.91 0.76 0.75 0.80 0.69 1.00

Japan 0.70 0.79 0.80 0.54 0.49 0.45 1.00

United Kingdom 0.87 0.87 0.87 0.93 0.66 0.76 0.52 1.00

Germany 0.83 0.82 0.82 0.92 0.66 0.74 0.42 0.77 1.00

Australia 0.76 0.76 0.75 0.74 0.75 0.67 0.49 0.72 0.65 1.00

Italy 0.70 0.73 0.73 0.78 0.56 0.57 0.42 0.63 0.72 0.54 1.00

As of 31 December 2015

Data from 1990–2015

Source: MSCI

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have outperformed US large cap equities for extended periods. Investors who exclusively held US stocks would have missed the out-performance of non-US equities—developing and emerging—from 2002–2007 as well as in 2009 and 2012.

Market leadership among individual countries has also shifted regularly. While the United States has led returns in three of the past five years, these are the only times in the past two decades that the United States has occupied the top spot. The lead developed markets equity performers over the past decade have included countries from all over the world: Spain, Germany, Japan, and Australia (Exhibit 3).

A World of Opportunities In addition to diversification benefits, non-US equities offer a broader opportunity set. More than 10,000 companies are included in the MSCI ACW ex-US All Cap Index, while the number of US companies in the MSCI ACW All Cap Index is about 3,500. By eliminating home bias, investors can take advantage of a much larger investable universe (Exhibit 4) that includes companies with household brand recognition, such as Anheuser-Busch, BMW, Novartis, and Sony.2

GDP Growth Is Not Equity Market GrowthRecently, US GDP growth has been relatively strong in the global economy, especially compared to other developed markets. This performance, along with investor confidence in future US growth, has helped push US valuations higher in both historic terms and compared to other regions. However, investors should be aware that

Exhibit 3Periodic Chart of Country Performance since 1995

MSCI’s Country Indices measure the performance of individual developed country stock markets. For comparison purposes, over a 20-year time period, Lazard has chosen to feature the 10 largest, in terms of float-adjusted market cap, developed markets country indices that compose the MSCI World Index as of 31 December 2015. All returns in US dollars.

An investment cannot be made directly in an index. Indices are unmanaged and have no fees.

The performance quoted represents past performance. Past performance is not a reliable indicator of future results.

Source: MSCI. Each country’s return is represented by its respective MSCI country index. Net dividends reinvested.

Exhibit 4A Broader Opportunity Set

US Companies Make Up Little More than One-Half of Global Market Cap . . .

France 3%

Germany 3%

Switzerland 3%

China 3%

Canada 3%

Australia 2%

Other 16%

UnitedStates53%

UnitedKingdom 6%

Japan 8%

. . . And About a Quarter of Listed Companies

MSCI ACW All Cap ex-US76%

UnitedStates24%

As of 30 June 2016

Source: FactSet, MSCI

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market performance and GDP growth are not directly related. A study by Jay Ritter at the University of Florida in 2012 concluded that no correlation existed between GDP growth per capita and local stock market returns.3 When Ritter analyzed stock market returns and per capita GDP growth for 19 countries from 1970–2011 (Exhibit 5), he found no correlation. When he considered 15 emerging markets from 1988–2011, the correlation was negative. In recent years, Japan, Greece, Italy, and Spain have all generated slow or negative GDP growth in years that their stock markets have risen.

Many US-based investors have also been concerned about the poten-tial impact of currency movements on returns. While currency values can change dramatically over the short term, the impact over time tends to fade. The US dollar rose sharply in the second half of 2014 and early 2015, which significantly reduced non-US security returns for US-based investors. However, over the long term, the impact of this move on US dollar-based equity benchmark performance has been marginal.

Going Abroad: Potential for Outperformance Active managers have been able to generate more excess returns out-side the United States than within it (Exhibit 6). Active managers seek to exploit market inefficiencies and make specific investments with the goal of outperforming an investment benchmark. For most of the past ten years, international equities managers have outperformed the MSCI ACW ex-US Index more than US managers have outperformed the S&P 500 Index. On an annualized basis over the past three, five, and ten years, this pattern has become consistent, with the outperfor-mance significant. In absolute terms, more than half of international managers have outperformed the ACW ex-US Index in eight of the past ten years.

One reason for the difference in performance may be that non-US mar-kets have less coverage. A lower number of analyst recommendations are made for non-US companies than US companies, and analysts update their earnings estimates on a less frequent basis. For non-US managers, it appears easier in this environment to find new ideas and develop the unique insights that can generate outperformance.

While large cap US equities have outperformed non-US equities over the past few years, this performance may not be maintained indefi-

Exhibit 5Economic Growth and Market Returns Are Not the Same

0

3

6

9

(%)

USD Stock Returns

Local Stock Returns

Real Annual per capita GDP growth

Swed

en

Finl

and

Sout

h A

fric

a

Den

mar

k

Net

herla

nds

Ger

man

y

Nor

way

Bel

gium

Can

ada

Uni

ted

Stat

es

Uni

ted

King

dom

Switz

erla

nd

Fran

ce

New

Zea

land

Aus

tral

ia

Irela

nd

Spai

n

Japa

n

Ital

y

As of 31 December 2011

Data from 1970–2011

Source: Jay Ritter, University of Florida, Journal of Applied Corporate Finance, Volume 24, Number 3, Summer 2012 (a Morgan Stanley Publication)

Exhibit 6Non-US Equity Managers Have Been More Effective

Percentage of Managers Who Beat the Index: US versus EAFE versus ACWI ex-US

(%)

0

25

50

75

100

Last 10 YearsLast 5 YearsLast 3 YearsLast Year

S&P 500 Index MSCI ACWI ex-US IndexMSCI EAFE Index

As of 31 December 2015

The performance quoted represents past performance. Past performance is not a reli-able indicator of future results. This information is provided for illustrative purposes only and does not represent any product or strategy managed by Lazard. it is not possible to invest directly in an index.

Source: eVestment

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nitely. We believe the time is favorable to reduce home bias by starting or increasing a non-US allocation, as non-US valuations are low rela-tive to the United States (Exhibit 7). This reflects the recent strength of the US economy relative to other regions, but we also believe it can represent an opportunity for skilled investors who are looking ahead. Historically low interest rates have also prompted investors to search for higher yield in assets around the world. International developed markets, especially in Europe, offer relatively attractive yields, and emerging markets yields are competitive as well.

An Active Approach to Non-US MarketsLazard’s International Equity investment strategy is based upon the team’s belief that the level, sustainability, and direction of a company’s financial productivity are critical drivers of its stock price. Financial pro-ductivity is reflected in a number of data points, such as return on equity (ROE). By analyzing factors that could impact the sustainability and trajectory of ROE, we judge which companies we believe appear fully valued and which may be attractive to us. The goal is to find companies that are financially productive and relatively inexpensive when com-pared to the level of returns. By blending these kinds of companies into a well-balanced, risk-adjusted portfolio, the strategy aims to offer partici-pation in market rises while protecting principal during downturns.

The foundation of the International Equity team’s approach is funda-mental research. It seeks a thorough understanding of each company, including key drivers of profitability, management, and balance sheet strength and sustainability. The portfolio managers have the flexibility to pursue opportunities across geography, sector, and market cap.

The team’s process is strongly supported by Lazard’s extensive resources as well as its culture. Lazard has been investing in the international equity markets for two decades, and the firm employs more than eighty investment professionals to cover non-US companies. Lazard’s International Equity portfolio managers draw upon the firm’s global research analysts—sector and regional experts located in Asia, Europe, the Middle East, and the United States. In our view the caliber and breadth of our global sector specialists provide our investment teams with unique information and local insight, while our investment philosophy and analytical resources give us an edge in processing it. In addition, the organization of the analysts into sector teams is anchored in Lazard’s belief that where and how a company does business is more important than where it is domiciled.

Historically, our focus on returns-based investing has enabled us to deliver consistent performance over the long term. Lazard International Equity has historically participated in rising markets while protecting capital in falling markets, thereby compounding longer-term returns from a higher base.

ConclusionReducing home bias in portfolios can offer investors greater diversifi-cation benefits and more access to investment opportunities. Non-US equities can be varied sources for returns as economies and markets perform differently. They also provide access to strong companies, management teams, and strategies. Investors should also be aware that skilled managers may have more opportunities in non-US equities than do managers in the more efficient US large cap market. With non-US equities currently cheaper than US equities after several years of US outperformance, we believe it’s an opportune time to consider eliminating home bias in portfolios.

Exhibit 7Non-US Equities Appear to Be Cheaper than US Stocks

Forward P/EaForward ROE

(%)aDividend Yield

(%)

Emerging Markets 13.6 11.5 2.6

Japan 14.2 8.4 2.3

Asia 14.9 8.7 2.8

EAFE 15.7 10.0 3.3

Continental Europe 15.8 10.9 3.4

United Kingdom 17.6 11.2 3.9

United States 19.0 14.6 2.1

As of 30 September 2016

a Forward Price/Earnings is defined as Price/Earnings FY1 and Forward Return on Equity as Return on Equity NTM.

The figures above represent expected returns. Expected returns do not represent a promise or guarantee of future results and are subject to change.

Indices: United States = MSCI USA Index; Continental Europe = MSCI Europe ex-UK Index; Japan = MSCI Japan Index; Emerging Markets = MSCI EM Index

Source: I/B/E/S Consensus, Lazard, MSCI

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This material is provided by Lazard Asset Management LLC or its affiliates (“Lazard”). There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past per-formance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard’s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect invest-ment performance.

Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 29, Level 8, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for “professional investors” as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, 04520. People’s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only. The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal, or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W. This document is for “institutional investors” or “accredited investors” as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.

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Notes1 Coval, Joshua D. and Tobias J. Moskowitz, “Home Bias at Home: Local Equity Preference in Domestic Portfolios,” The Journal of Finance, Vol. LIV, No. 6, December 1999.

2 Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assur-ance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.

3 Ritter, Jay R., “Is Economic Growth Good for Investors,” Journal of Applied Corporate Finance, Volume 24, Number 3, Summer 2012.

Important InformationPublished on 20 December 2016.

Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opin-ions expressed herein are as of 15 December 2016 and are subject to change.

The Citigroup Economic Surprise Index measures economic data relative to forecasts. The index rises when economic figures beat projections and is negative when they disappoint forecasts.

Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy.

Investments in Japan are subject to certain risks, such as the risks associated with the economy of Japan generally. A portfolio of securities concentrated in one country or geographic region may be subject to greater volatility than a more diversified portfolio.

Diversification does not guarantee profit or protect against loss in declining markets.

About the International Equity Team

Lazard’s International Equity portfolio managers draw upon the firm’s global research analysts—sector and regional experts located in Asia, Europe, the Middle East, and the United States. Their combined insights, ideas, and observations are leveraged by each strategy’s portfolio manag-ers/analysts, deploying the firm’s full expertise on behalf of clients. In our view the caliber and breadth of our global sector specialists provide our investment teams with unique information, while our investment philoso-phy and quantitative resources give us an edge in processing it. The teams have been implementing the same process and philosophy to international equities for several decades.