U.S. stocks have consistently outperformed their international peers over the past three decades, but AQR Capital Management cofounder and chief investment officer Cliff Asness believes the streak may be coming to an end.
“Looking back, U.S. outperformance since 1990 can largely be explained by relative richening against other equity markets,” the billionaire investor wrote in an article for The Journal of Portfolio Management released April 28, describing how American stocks have become increasingly expensive compared with international counterparts. “Investors betting on continued U.S. outperformance may be making a perilous assumption that this richening will continue, despite historically high relative valuations suggesting the opposite is more likely.”
Asness is big on portfolio diversification, which has been shown to improve long-term returns. He argued that U.S. investors should look to international stocks to diversify their portfolios because they present solid relative value based on cyclically adjusted price-to-earnings (CAPE) ratios. The CAPE ratio, developed by Nobel Prize–winning economist Robert Shiller in 1988, has long been one of investors’ favorite ways of gauging if stocks are cheap or expensive. It seeks to average out the peaks and troughs that naturally occur in corporate earnings by looking at a 10-year average of profits, adjusted for inflation, giving investors a more accurate measure of relative value.
Comparing the CAPE ratio for the MSCI USA Index—which tracks large and midcap U.S. equities, and the MSCI EAFE Index—which tracks large and midcap equities across 21 developed countries in Europe, Asia, Canada, and Australia, Asness found that U.S. stocks traded at a record high valuation relative to their international peers in 2021, and remain near those levels even now. And “valuations count,” the hedge funder argued. “Research has shown, and simple economic logic would support, that countries selling at lower valuations (lower price to fundamentals) should have a higher long-term expected return.”
It may make sense to pay attention to Asness’s call, too, as the hedge funder has had a career full of repeated success. Starting at Goldman Sachs Asset Management’s “quantitative research” desk in the early ’90s while finishing up a Ph.D. in finance at the University of Chicago, Asness helped develop a mathematical approach to investing that used models to identify patterns in markets.
By 1995, Asness’s group started an internal hedge fund at Goldman that returned 140% to investors its first year. The fund was eventually rolled out to the public as the Goldman Sachs Global Alpha Fund, and in just two years Asness was at the helm of the quantitative research group that managed $7 billion within the firm.
Asness then took his mathematical approach to investing to AQR Capital Management in 1998, founding the firm alongside David Kabiller, John Liew, and Robert Krail and growing it into one of the world’s largest hedge funds. In 2011, Fortune detailed AQR’s transition from a quantitative hedge fund meant only for institutional investors into an investment firm that also offers mutual funds and private funds for average consumers.
It hasn’t always been smooth sailing for Asness, though. After a lengthy period of subpar returns between 2018 and 2020, some investors fled AQR in 2021. But the hedge funder proved his mettle last year.
The S&P 500 might have dropped roughly 20%, but multiple AQR funds managed a record performance, Bloomberg reported in January, citing unnamed sources. The Equity Market Neutral Global Value and Global Macro strategies, for example, returned 44.7% and 42.0% net of fees, respectively. And the AQR’s longest-running strategy, called Absolute Return, netted 55% before fees last year, its best performance since 1998.
Asness isn’t alone in his view that international equities are a solid option for investors either. While U.S. equities have outperformed their international counterparts eight out of the past 10 years, according to data from BlackRock, when U.S. markets have down years, international stocks offer upside. Historically, international stocks outperformed 96% of the time when U.S. stocks returned less than 6% in a year, and 100% of the time when U.S. stocks returned less than 4%.
“Despite lagging in recent years, international stocks have performed strongly throughout history, outperforming U.S. stocks during nearly half of all time periods over the last 50 years,” BlackRock’s researchers wrote in a recent report. “With lower returns forecasted for U.S. stocks over the coming years, international stocks may be primed to outperform.”
UBS Global Wealth Management CIO Mark Haefele also said in a Wednesday note that he believes investors should “diversify beyond the U.S. and growth stocks.”
“After a strong start to the year, U.S. equities are pricing a high chance of a soft landing for the U.S. economy, yet tighter credit conditions, declining corporate earnings, and relatively high valuations all present risks,” he wrote. “By contrast, we like emerging market stocks, powered by a weaker dollar, rising commodity prices, strong earnings growth, and China’s stronger-than-expected recovery, alongside select opportunities in Europe.”
