VOO: Global Revenues And Global Diversification Are Not The Same

After writing several articles about passive investing in the US (see here for the S&P 500 and here for the total market) and challenging the idea of “US-only” (see here), I received one particular comment multiple times: the idea that you don’t need global diversification because US companies make some fraction of their revenues internationally.

There is nothing generally wrong with this argument and I thank all readers who brought it up in the comments. However, as will hopefully become clear from this article, holding companies with global revenue is not the same as holding a global portfolio of stocks. But let’s go through it step by step.

The global exposure of the S&P 500

First of all, and I think it is important to mention this explicitly, the argument that S&P 500 companies increasingly make their revenues internationally is true and in-line with the data.

In February 2018, S&P Global (the index provider of the S&P 500) published a blog post showing that “[…] approximately 29% of S&P 500 revenues came from overseas in 2017.” They also show that this fraction is somewhat lower for small and mid caps which, in my opinion, is quite reasonable. A more recent analysis from FactSet shows that about 40% of S&P 500 revenues came from overseas in the fourth quarter of 2022. FactSet also did this analysis in previous quarters and the composition was relatively stable around 60% US / 40% International.

So yes, it is true that the S&P 500 offers some degree of global exposure via the underlying companies’ fundamentals. It is also noteworthy that this effect became stronger over the last years as the fraction of international revenues increased by about 10%-points since 2017. Moreover, it is quite interesting that the current composition of 60/40 is roughly similar to the US’ weight in market-cap weighted global indices. However, I would argue that this is not a causal relation.

Diversification depends on perspective

For the following, it is important to understand that diversification always depends on your perspective. You can invest in just one globally-operating company and argue that you are diversified because of the underlying operations. This is not wrong, but at the same time, you can also argue that this is concentrated because you leave out all other investable stocks. You could even argue that investing in the broadest possible stock market ETF is still not diversified because you leave out other asset classes. To not confuse anyone further, I stop here but I think the general idea came through. Diversification always depends on the universe you are looking at (or the universe that is available to you).

As I mentioned in my last article, the Vanguard S&P 500 ETF (NYSEARCA:VOO) is (in my opinion) the best instrument to get exposure to the S&P 500 which is a reasonably well-diversified index for equities within the US. That said, it still leaves out a substantial part of the opportunity set from a global perspective.

Global revenues won’t help when the US underperforms

Back to the global revenues of S&P 500 companies. This fundamental exposure to global markets indeed offers an additional layer of diversification. Holding a portfolio of large and globally-active firms makes your portfolio less dependent on the US economy and you can easily make the argument that this stabilizes revenues, earnings, and ultimately the stock prices of the underlying companies. This is great and certainly better than holding a portfolio of companies with purely domestic revenues. But it is just a first step.

If you take a step back and look at the global opportunity set of currently about 9,500 stocks, you are just investing in about 5% of the companies. Although these 5% make up about 35-40% of the global market-cap, this still leaves substantial room for error. Yes, the US and the S&P 500 in particular was by far the most attractive stock market over the last decades and I don’t want to open the US vs. International debate too much at this point. But in general, it is absolutely possible that the US (or any other) equity market will underperform the global benchmark in the future.

This is an undeniable risk of the S&P 500 / VOO and the global revenues of the underlying companies won’t help you if investors are not willing to bid up the US market. Global revenues may make an underperformance of the US market less likely, but if it happens, they will not save you.

In fact, there is a lot of research on the issue. AQR, for example, concluded back in 2011 that although international diversification will not help in short-term crashes (if things get really bad, everything typically falls together), it is very beneficial over the more important long-term:

[Global] Diversification protects investors against the adverse effects of holding concentrated positions in countries with poor long-term economic performance. Let us not fail to appreciate the benefits of this protection.

Asness et al. (2011, p.34), “International Diversification Works (Eventually)”

In a short paper from April 2021, Vanguard arrives at a very similar conclusion and shows that investors can improve their portfolios by also investing in non-US stocks.

A counterexample: the Eurozone

One of the nice things about the scientific method is the fact that one counterexample is sufficient to kill a hypothesis. So let me give you one to show how global revenue exposure is helpful, but not the same as true global diversification.

A common benchmark for the stock markets of the Euro Zone is the EURO STOXX Index by Qontigo, another index provider. As we all know, Europe massively underperformed the US over the last years. However, apart from the “normal” EURO STOXX Index, Qontigo also calculates the EURO STOXX International Exposure Index. According to the methodology, this one explicitly overweights companies that “[…] generate a substantial portion of their revenues outside of the Eurozone.”

That makes it the perfect instrument to test our hypothesis. The following table summarizes some performance statistics. To avoid breaks in the index methodology, I also use STOXX indices of the US (USA 500) and the global market (Global 1800) for comparison. Although less known, these indices are de facto similar to the S&P 500 and MSCI World, respectively.

Click to enlarge

Gross returns in EUR as of December 30, 2022 (net returns for IE due to data availability). Source: Index Factsheets from Qontigo.

Looking at the longest 5Y period, we clearly see the strong outperformance of the US. The STOXX USA 500 returned 11.9% per year versus a disappointing 3.5% for the EURO STOXX, and a still quite good 9.1% for the STOXX Global 1800. This already shows the danger of betting on the wrong country/region…

In line with the idea that global revenues mitigate this problem to some extent, the EURO STOXX International Exposure Index outperformed the parent index by 1 and 1.4%-points over the last 3 and 5 years, respectively. Global operations of the underlying companies therefore indeed helped and mitigated the underperformance.

However, the returns of the International Exposure Index are still much worse than those of the STOXX Global 1800 (-2.6 to -4.2PP per year, depending on the period). Investor who diversified globally did not capture the impressive 11.9% p.a. from the US, but they still earned a decent 9.1% p.a. from global markets (including the US). Needless to say, this is much better than what any of the two European indices delivered over the same period. This little example shows that although somewhat helpful, global revenues don’t save you when you bet on the wrong region in the first place. Only true global diversification within a portfolio does.

Conclusion

This article was mainly a reaction on the comments that I received for my earlier work. However, I still believe that the Vanguard S&P 500 ETF is an outstanding instrument to track the S&P 500 Index. It is dirt cheap, performed better than peers in the past, and is run by a manager with an outstanding reputation. In short, it is probably the best vehicle for investors who want to bet on US large caps and a solid core for many portfolios.

Importantly, however, it is not more than that. Yes, you have some global exposure via the underlying companies’ operations. But that is unlikely to save you when the US market underperforms the rest of the world. The US massively outperformed international markets in the past and there are plausible reasons why the US could be a systematically better place to invest (one of the freest market economies, successful public companies, the most developed financial system, a large domestic market, entrepreneurial culture…). On the other hand, however, much of the last decades’ outperformance came from continuous multiple expansion (see this note from Cliff Asness) and I think it is difficult to assume that this can continue forever.

As I also mentioned in my article on the Vanguard Total World Stock ETF (VT), it is absolutely possible that the US market will underperform the rest of the world for quite some periods in the future. Today it is hard to imagine, but there were such periods in the past. The argument for global diversification is therefore as strong as ever before and I think investors should not only rely on global revenues from the underlying companies but also add some non-US equities to their portfolios (sorry for repeating myself).

It is fine to believe in the US and the S&P 500 and still overweight it with respect to the global benchmark. But even if you don’t want to move to the truly global VT, you can certainly improve your portfolio with a small allocation to international equities (for example, via the Vanguard FTSE All-World ex-US ETF (VEU)) even though the past performance looks poorer. By definition, diversification means to not only hold the winners (that’s alpha). I know this sounds somewhat unsexy, but it helps to avoid bets on the wrong countries. Just having companies with global revenues does not.