Why you need to think about valuation and concentration risks when investing globally
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Shares Magazine
The principle of reducing risk by spreading investments across different sectors and companies can be given another layer of diversification by considering investing in international markets.
Helpfully, there is an excellent range of products and instruments which allow you to participate in the returns from markets across the globe.
While there are additional risks to consider when investing internationally like currency fluctuations and different accounting standards, there are also advantages.
These include getting access to industries not well represented in the UK, such as technology in the US, semiconductors in Taiwan, pharmaceuticals in Switzerland and automation in Japan.
Emerging economies have better growth profiles driven by younger populations and rising middle classes with India and Vietnam being prime examples.
International markets can trade on lower valuations because of higher political uncertainty or temporary economic weakness.
Global equity trackers are very concentrated
An effective and cheap way to achieve global equity diversification is by buying ETFs (exchange traded funds) which track one of the two leading global equity indices.
The MSCI World Index tracks developed equity markets while the FTSE All World Index tracks both emerging developed and emerging markets. As the chart shows the MSCI World has handily outperformed the FTSE 100 over the last 10 years.
It is worth bearing in mind that due to the strong performance of US markets over the last 15 years, global indices are more concentrated than they were a decade ago.
The US represents around two thirds of the index, up from 45%, while the top 10 companies make up a quarter of the index versus roughly 10% in 2016.
Top holdings are dominated by large US technology companies including Nvidia, Apple, Microsoft, Amazon and Alphabet.
Higher concentration reduces some of the potential diversification benefits while a significant US valuation premium raises risks that future returns may be lower.
Is the US valuation premium sustainable?
Undoubtedly the US is home to some of the fastest growing technology companies at the cutting edge of the AI revolution.
Goldman Sachs recently raised its 2026 earnings per share forecasts for the S&P 500, implying 24% year-on-year growth followed by a further 13% in 2027.
It may seem counter-intuitive, but anticipated earnings growth and stock market returns do not always move in lockstep. The main reason is that markets are forward looking.
For example, near the end of recessions investors typically look beyond near-term earnings growth (which will look awful) to anticipate economic recovery.
A similar pattern is often observed near the end of economic expansions, though in reverse as investors start to recognise that earnings assumptions may already be priced into valuations.
In simple terms, what you pay for growth is just as important as the growth itself which is always uncertain. As Oaktree founder Howard Marks has noted, buying a good company does not always make a good investment and overpaying can lead to trouble.
It is useful to think of valuation like a piece of elastic, the further it stretches beyond a certain point the more it is likely to spring back to normal.
As the table shows, the S&P 500 trades on almost double the forward PE (price to earnings) ratio of the MSCI Emerging markets index.
The rating has expanded from around 1.3 times a decade ago and a similar trend can be seen for the FTSE 350 index which was trading at parity with the US as recently as 2016.
The relative cheapness of the UK market against the US goes some way to explaining the raft of takeovers seen in the UK over the last few years.
Emerging markets and Japan outperform
Valuations are not a direct guide to future performance, but they can play a role in identifying imbalances in underlying market sentiment which are ripe for reversal.
Despite the S&P 500 making all the headlines with record breaking highs the Japanese Topix index and the MSCI World index have both outperformed the US benchmark over the last year.
This demonstrates one of the key advantages of having a genuinely diversified global portfolio of investments.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
