Diversification, as a fundamental component of prudent investment management, has tested the patience of investors over the most recent bull market in US equities. International equities have trailed by a significant margin in relative performance since late 2011, weighing on the returns of a globally diversified portfolio versus a US only investment strategy. In this piece, we take a longer view of global diversification and compare the current valuations of US and international markets.
US Equities again proved to be the best performing major asset class with a return of 12% in 2016. During the year we experienced rapid sector rotations with large swings in performance from quarter to quarter. Energy was the best performing sector, following a dismal few years, and traditionally defensive sectors such as Telecom and Utilities also posted good relative results for the first three quarters of 2016. The fourth quarter was dominated by the performance of the financial sector responding to rising inflation expectations and the potential for decreased regulation from the new administration. On a trailing five-year basis, US Equities have been the clear market leader with large caps and small caps performing comparably.
On the International equity side: Emerging Markets benefited from their commodity exposure and delivered an 11% return for the year, while Developed Markets returned only 1%. Developed Markets have outperformed Emerging Markets over the last 5 years, although over the last 10 years both are lagging most other asset classes.
Intermediate Treasury bonds returned 2.0%, while longer bonds returned 1.3%, hurt by rising interest rates in the second half of 2016. High yield bonds delivered particularly strong results as spreads narrowed considerably and credit quality concerns abated. High yield improved 17.5% in 2016.
The alternative asset class returns were unimpressive for 2016 with the exception of commodities which, led by energy, returned 11.4%. Most equity hedge funds were below the S&P 500 and as a group have not outperformed the market since 2008.