The past several years have not been kind to the diversified global investor. Although large cap domestic and European stocks have done well over the past decade, the Far Eastern and Emerging markets have fared poorly, and in all areas small stocks have underperformed their larger cousins.

Our cowards, who spread their bets widely across the globe and market cap, have suffered accordingly. (For more information about the exact makeup of the cowards, click here.) Their performance relative to the actively managed competition (Morningstar's "asset allocation" and "global multiasset" mutual funds) has begun to slip. The reason for this is that the actively managed funds generally use an orthodox allocation model, with large cap US stocks being the dominant component. Since the S&P has been the hottest global asset category over the past 5 years, this has favored the actively managed funds. The 3, 5, and 10 year plots are shown below:

Roughly speaking, the cowards have maintained their superior 10 year performance, have slipped to merely average over 5 years, and actually perform worse than the actively managed funds over the past 3 years. Unless the large cap US/European dominance of the past several years continues the cowards should bounce back, but no excuses are offered.

Active versus Passive
A more subtle, and troubling, phenomenon is evident in the 3 and 5 year data. Over both periods strictly passive global management seems to have fallen flat. The CEI and the ACEI, which are exclusively indexed, have underperformed the SICEI (the coward available to the average small investor), which of necessity contains some actively managed funds. All three strategies underperform by a wide margin the Tweedy-Browne strategy, which is entirely actively managed along classic Graham-and-Dodd lines.

Those of you familiar with these pages know that there is a powerful body of evidence that even the "best" professional managers cannot pick stocks or time markets, and that a passive strategy beats the active manager most of the time. (The folks at DFA, as is their wont, refer to this as "active manager risk.") So what's going on here? First, the Tweedy and SICEI strategies are not as exposed to the Far Eastern markets as the CEI and ACEI, and have benefitted accordingly. But there may be something else going on as well.

A purely passive global strategy buys the "global market" in cap weighted fashion. In other words, if the market cap of country A is 10 times that of country B, then the strictly indexed global investor will own 10 times as much A as B.

This tends to overweight the most expensive nations, and underweight the cheapest. For example, in 1989 the Japanese market contained nearly 50% of global market capitalization, whereas now it makes up less than 15%. The investor whose global allocation mirrored the 1989 market caps suffered mightily.

Many global managers, including our friends at Tweedy-Browne, recognized this problem and largely avoided Japanese equity. (With the deflation of Japanese equity this has changed. Tweedy now considers Japanese equity the cheapest in the developed world, and is beginning to overweight it.)

Put another way, while managers may not be able to time markets or pick stocks, the global Graham-and-Dodder may just be able to choose countries to advantage.

The cowards are not (as some readers have assumed) portfolio recommendations carved in stone. They are a work in progress, intended to explore the basic allocation issues facing small investors. Stay tuned.

copyright (c) 1998, William J. Bernstein