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Rekenthaler Report

Revisiting International Equity Indexing

The case for indexing overseas is stronger than first appears.

Another Look
In 2013, I adjudicated a debate between an academic who supported actively managing international equities, and a practitioner who advocated indexing. (Role reversal!) After reviewing the evidence, I took the middle ground. Indexing is always a viable strategy, but, I wrote, it must be granted that the case for active management is stronger with international stocks than with U.S. companies.

Today's column updates its predecessor, incorporating subsequent market performance. Its argument is much more direct. The 2013 article, it must be confessed, meandered rather badly. This column will take the straightest of lines.

  1. How does the performance of international-stock index funds compare with that of U.S. equity indexers?
  2. If there were differences, explain why and assess whether those differences will persist.

Three Tiers
We'll start with U.S. index funds--specifically, those in the large-cap blend Morningstar Category, as opposed to specialized fare. Such funds, we are told, comfortably outgain their average actively managed rivals over time. That has indeed been the case. Over the trailing 10 years through Sept. 30, 2019, every single large-cap blend index fund beat the category average. There were no exceptions.

Indeed, it would have been surprising if there had been, because almost all such funds mimic one of two benchmarks: 1) the S&P 500 or 2) the Wilshire 5000. And those benchmarks are closely related, as S&P 500 stocks account for about 80% of the Wilshire 5000. (Not in numbers, of course, but in portfolio weighting, as the indexes hold each company in proportion to its stock-market value.) Thus, all large-blend index funds perform similarly.

But they don't perform identically. They landed in three tiers. The top index funds were based on the S&P 500 and had negligible expense ratios. Their 10-year category return rankings were at the 10th percentile. The second tier consisted of mid-priced S&P 500 funds and the very cheapest of the Wilshire 5000 funds, which placed at the 20th percentile. At bottom were the costliest of the indexers, which placed between the 25th and 35th percentiles.

Home Cooking
In short, all the U.S. large-blend equity index funds were relative winners. Their risk scores were less impressive, landing roughly in the category's middle, but they certainly weren't bad, particularly as--indexing's critics like to point this out--the funds are always fully invested and therefore can't be expected to dodge bear markets. (Admittedly, neither can active managers, but some like to pretend otherwise.)

In contrast, performances of the major international-stock index funds were less impressive. On average, both the relative returns and relative risks for the mainstream international-stock index funds were just that: average. Every foreign large-blend index fund landed between the 27th and 63rd percentiles for returns and between the 36th and 60th percentiles for risk. The middle of the road was thoroughly hugged.

We now have the answer to this column's first question. The relative risks for large-cap indexing, whether in U.S. stocks or internationally, have been similar. All the index funds were roughly as volatile as the typical actively run fund. However, while the relative risks for U.S. and international index funds aligned, the relative returns did not. The U.S. index funds comfortably outgained their category's average, while the international-stock index funds matched the norm. The question is why.

The Winds of Fortune
I have an answer: The U.S. index funds rode a tailwind, while the international indexers faced a headwind.

For reasons I can't fully explain, managers who run active large-company funds--both those who buy U.S. stocks and those who invest internationally--almost always try to outsmart the indexes by buying smaller companies rather than loading up on their index's top holdings. Therefore, when large-company stocks outperform smaller companies, the index funds enjoy a structural edge. They don't win just because of their lower costs; they also win because they hold the better portfolio for that environment.

Such has been the case over the past decade, when in the U.S. blue chips modestly outgained smaller companies. That discrepancy explains why the S&P 500 funds slightly beat their Wilshire 5000 rivals (assuming equal expense ratios). The S&P 500 does not hold the smaller firms that fill out the Wilshire 5000's portfolio. That also helps explain why both indexes outdid the typical actively run large-blend fund, which holds even smaller companies.

The wind blew in the other direction for international equities. Overseas, the smaller companies outdid the blue chips. Of all international-stock index funds with 10-year records, the two highest-returning were the two funds that follow small-company benchmarks. Bigger has been better for U.S. equity investing over the past decade, but not so in most other major markets.

No surprise, then, that the foreign large-blend index funds struggled to keep pace with their active competitors. Those who indexed U.S. stocks had the good fortune of running with the wind. Those who did not had to run against it. That accounts for much, if not all, of the performance discrepancy between the two versions of indexing.

An Even Contest
The final issue: Will those issues persist? That I cannot say. Few if any can predict which investment styles will prevail. I can say, though, that unlike many observers, I regard the contest as roughly equal. Adjust U.S. large-blend index funds for their tailwind, and their 10-year return rankings would drop to about the 25th percentile. Similarly, adjusting foreign large-blend index funds would raise them to much the same place.

In 2013, I thought that the case for equity indexing was good for international stocks, but not as strong as with U.S. securities. I no longer believe that to be true.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.