Top 5
In a broad-based and growing global economy, investors often miss out on the opportunity to realise the advantages of global diversification within their portfolios. This is in part due to the perception that a domestic-focused approach provides less risk. In fact, the opposite is often true. Historical analysis reveals that when compared to a domestic-only strategy, portfolios with global holdings have typically, over time, earned higher returns for the same level of risk or produced less risk for the same level of return.
Although past performance does not guarantee future results, this may suggest that investors should assess their diversification strategies and, where appropriate, adjust their allocations to achieve an optimum level of non-domiciled holdings while looking for investments that will provide low correlations with their domestic holdings.
Since 2000, more than half of global GDP growth was driven by emerging markets, led by the BRIC nations, producing double-digit growth rates. Investors who were positioned in these emerging countries – as well as other countries – were rewarded over those who were exclusively in US equities or only invested in advanced countries. In a study by investment managers Gerstein Fisher (see Fig. 1) covering 1999 to 2013, a globally diversified portfolio outperformed a US-only portfolio in 96 percent of rolling three-year periods, with a total outperformance of 35 percentage points over 13 years.
Since 2000, more than half of global GDP growth was driven by emerging markets, led by the BRIC nations, producing double-digit growth rates
Aligning a global economy
Although growth in the BRICs has slowed, many emerging and developing countries are poised for growth rates that may surpass advanced economies. According to the IMF in April 2014, global growth is projected to be 3.6 percent in 2014 and 3.9 percent in 2015, with China projected to grow at more than seven percent and India more than five percent. Several developing countries are poised for growth above the average. Through global diversification, investors may best capture value across the entire economy and may realise better risk-adjusted returns.
While the data provides a sound rationale for global diversification, investors have been reluctant to adopt strategies that align portfolio allocation with market capitalisation. Currently, US equities comprise approximately 49 percent of the global market, so investors may consider having 49 percent of their portfolio in US equities and 51 percent in non-US equities.
However, studies show that few investors would be comfortable with those allocations due to a range of factors, including a preference for domestic equities, familiarity with local issues driving market performance, and access to information on global investments, as well as regulatory constraints.
For example, according to a 2012 study US investors maintained an allocation to US stocks that was approximately 1.7 times the weighted market cap of US stocks, while investors in the UK maintained a relative home bias of about 6.25 times the market cap of UK stocks.
It’s important to recognise that market cap is only one consideration for diversification and, historically, investors would have obtained substantial diversification benefits from allocations that varied considerably from current market-proportional portfolio. Specifically, looking at short-term performance in the past decade, there are periods of time where allocating 20 percent of an equity portfolio to non-US stocks would have captured about 85 percent of the maximum possible benefit.
Therefore, our recommendation is that investors carefully consider how global diversification may support their underlying investment strategy and, where suitable, gradually increase the percentage of their portfolio allocated to international equity. If an investor has no international exposure, setting a target of 10 percent may be an appropriate goal. For someone with 15 percent in international, we suggest 20 percent or more where appropriate, while looking specifically to strengthen the risk/return characteristics of the portfolio.
In particular, those countries with a low correlation with the investor’s domestic economy can often be more beneficial in maximising the value of diversification. Countries in the EU for instance, typically have a much higher correlation to the US than most other countries, so the positive effects of diversification may be better achieved with investments in countries like Mexico, Brazil and Taiwan, where the correlation to the US economy is lower.
One common misconception is that investment in multinational companies – particularly US-based multinationals – can provide global diversification coverage. But a closer look at the international footprint of Standard and Poor’s 500 companies shows that the majority of their business remains in developed countries, so correlation remains high.
Finding the right market placement
Once an investor sets an allocation, it can be a challenge to determine which countries, sectors and products to consider. Fortunately, there are many financial products that make global diversification easier than ever. Investors can often achieve their global coverage objectives with just one strategic fund. For example, a single Exchange Traded Fund (ETF) can track a fully diversified international index and provide broad international exposure.
For more focused coverage of the largest, most financially developed countries consider an ETF that tracks a developed-markets ex-US index. Pair this with emerging-markets ETF to broaden international holdings and drive diversification. There are many other options, but the point is that achieving global goals can be relatively simple, low-cost, and targeted.
As investors can select from investments in more than 50 countries, one of the questions I frequently address is how to distinguish the three international market categories: advanced, emerging and frontier markets. Advanced markets include US, the EU and Japan, which tend to provide lower risk and more consistent returns. The emerging market includes countries that are in the process of establishing a more mature marketplace. This sector can encompass greater risk, along with the potential for greater rewards.
The frontier market essentially consists of companies and investments in nations that are less developed than emerging market countries, many of which do not have their own stock exchange. As of April 2013, Morgan Stanley has a list of 34 nations that it classifies in this market, including Croatia, Tunisia, Vietnam and Jamaica.
Historically, frontier markets have categorically been the riskiest markets in the world in
which to invest.
In tracking international markets for more than a decade, one of the most significant trends is the wealth of information and data now available to investors, advisors and financial professionals. But I think it’s important for us to distinguish direct reporting and analysis – where sources are on the ground – versus second hand interpretation of data. Much like I would place greater value on information on US markets from US analysts, I rely more heavily on professionals working in the regions or countries we are tracking.
In the Bank of the West Investment Advisory & Management group, we communicate regularly with our portfolio managers and banking partners around the world to compare information and shape strategies. These are often very focused discussions on whether forecasts and projections are aligned with the realities of the local economy and how financial, political and other forces can quickly reshape the economic situation.
One of the key lessons from working in this arena is the importance of actively managing international holdings – as tactical timing can be paramount in finding momentum that may carry specific markets downward, even as global growth accelerates or a regional economy is growing.
For example, as we look at emerging market countries, a real divergence has developed that requires careful attention. Some countries or regions, like China, are growing at or above seven percent while others like Latin America are closer to three percent, and still others like Brazil are facing recessionary pressures. So it can be particularly helpful to develop information sources that provide the level of market detail required to assess performance and recalibrate holdings as needed.
For investors who are interested in creating a globally diverse portfolio as well as those who are expanding their share of international holdings, small adjustments in allocation may produce significant benefits in terms of lower risk and higher returns.
For further information tel: +303.202.5428, or email: wade.balliet@bankofhtewest.com
