The theory behind investing globally in equities is well grounded, as it was first expounded by Bruno Solnik et al more than 25 years ago. In principle, by expanding the opportunity-set to include countries outside the home market, investors access a wider diversity of return streams with low intra-correlations and hence obtain better risk-adjusted returns. Pension plan investors have since increased the non-domestic proportion of their equity exposure, initially by increasing equity allocations or diverting money from their home market, and latterly by selling domestic equities to buy bonds, so rebalancing equity weightings to achieve a more global spread of assets.
As investors added foreign equities into the mix, they naturally looked immediately outside their home market for regional exposure, and subsequently added exposure to other continents and sub-sets of the equity market, such as emerging markets. In tandem, there has been a process of globalisation within the corporate sector, so that the profits stream of many companies bears little or no relation to their domicile. Analysis of companies within the MSCI World index determined that foreign sales were an aggregate 33% of total sales, so looking at a company solely in relation to its domestic market underplays a significant source of profits. Within investment banks and investment management houses, research analysts are increasingly re-organised along global sector lines, as opposed to having country or regional specialisation. Against this background, investing globally using specialist global managers makes sense.
In the view of State Street Global Advisors’ (SSGA) group chief investment officer Alan Brown, a broadly defined market cap based global portfolio of equities represents the closest approximation to the passive ideal described in the Capital Asset Pricing Model, which concludes that holding the market portfolio maximises expected risk-adjusted return. In the appendix to a paper published by SSGA head of investment research Eric Brandhorst, SSGA presents evidence that for investors based in the US, UK and Japan, risk-adjusted returns were improved by a move to a truly global passive portfolio, with no home bias or defined regional allocations, provided currency exposures were hedged. For US-based pension plans the improvement in Sharpe ratio is least, at just under 6%, probably because their market accounts for more than 50% of the global index. Moving to an unhedged global portfolio worsened the Sharpe ratio for the UK and US investor. Currency hedging but retaining the home bias improved Sharpe ratios for all investor types, but not by as much as for the portfolio fully cap-weighted across the globe. Japanese investors had the most to gain, with the Sharpe ratio improving by over 50%, whereas UK investors gained by approximately 20%. Brown argues that exposure to currencies other than that of the consumption basket adds to portfolio volatility without improving portfolio return, and that currency exposure should be systematically hedged in both active and passively run global equity portfolios.
Consultant and multi-manager group Frank Russell has independently studied home market equities as a hedge to liabilities and have found that the correlation is close to zero. Russell consultant Ian Barnes denies there is any rationale for a home bias at all, asserting that home equities are no less risky for the domestic investor than for any other class of investor in the long run. Barnes promotes the market cap weightings as common sense, as it invests most in the largest markets. However, Barnes is realistic, saying “a UK pension fund with 70% of its equity exposure in the UK will not adjust to 10% in one go. Shifts into foreign equities are occurring in 5–10% steps at each asset-liability modelling exercise.” Barnes reports that, as a result, the most advanced UK-based clients now have about 60% of their equity assets overseas. Dresdner RCM’s survey of UK investment consultants observes that, after bonds, global equities are the second fastest-growing asset class. Andrew Smith, partner at B&W Deloitte, suggests that this increase in global allocations may largely derive from a switch from equities into bonds, with UK assets being sold first.
The extent to which pension plans have moved away from home country bias towards a more globally spread equity allocation varies widely from plan to plan, although within individual countries there is some consensus. European investors have already gone through one exercise in diversification, by moving from domestic into Euroland assets, but many baulk at going fully global, which implies allocating more than 50% to the US. To avoid this high US exposure, consultants are recommending fixed regional weights, for example, in the UK a popular solution is a one third allocation towards each of US, Europe and the Asian markets. European pension plans are retaining a partial European bias, with approximately 50% in European equities and the remainder elsewhere. As BGI fund manager Stuart Owen reflects “in practice, global equities is ill-defined as an asset class and could mean just the US, Europe, Japan and the Far East, with possibly a 2% allocation to emerging markets”.
Much depends on the size of the domestic market, with investors in smaller markets realising early on that a home bias resulted in excessive concentration. In the 1990s, Dutch, Irish and Hong Kong-based pension funds already had overseas allocations of around twice their home market allocation, in marked contrast to UK funds, for which the proportions were reversed. Brown reports that Scandinavian, Belgian, Singaporean, Middle East and Australian funds are also more inclined to invest globally for this reason. Correspondingly, US funds feel less pressure to diversify globally. However, Brown reports a trend among US pension plans to allocate broader mandates, based on the All Countries ex-US World Index, whereas historically they might have allocated an EAFE and an emerging markets mandate. Some feel that giving global managers discretion to invest in emerging markets is a negative development, as Hans Danielsson, chief investment officer of AIG, avers “the emerging markets require knowledgeable, active and focused managers. Global managers may not have sufficient local knowledge, not only of how to invest, but when the timing is right.”
Geographic expansion by multinationals through merger and acquisition has meant that, for most developed markets, the top 5% of stocks account for in excess of 50% of market capitalisation (see table 1). This increases the stock-specific risk in individual country indices making industry biases a dominant factor in performance. As geopolitical boundaries and country weightings become less relevant, industry research is increasing in importance and it is here that investment managers are devoting the most resources. However, in some specific instances country factors have the biggest impact on stock price moves for example Nestlé, which has over 95% of sales outside Switzerland, yet still displays a correlation of 0.8 to the Swiss market index, as Owen explains, “due to asset/liability matching local investors are predominant in setting local prices”.
Quantitative analysis suggests that there are fewer benefits to global diversification since 11 September, with markets outside the US tracking movements in the Dow Jones Index to the tick. But UBS Asset Management global fund manager Wilson Philips feels this effect will be short-lived and that over a longer time frame sector and country performances differ widely.
Analysts and fund managers within global houses must be located in every region to achieve the appropriate level of specialisation. In addition, analysts will often be organised into global sector teams, which work to develop a house view on a sector, and spot valuation anomalies across markets. The benchmark FT and MSCI World indices contain over 1,500 stocks, so to cover them all thoroughly a massive analytical effort would be required. In reality, most focus on the top 90% of the index by market capitalisation, which is incorporated in the biggest 100–150 stocks. Barnes is of the view that managers that have adopted a global framework are more successful than those that attempt to fuse together regional portfolios. Barnes also favours a qualitative over quantitative approach, commenting, “markets will arbitrage out anomalies at different rates and for a quantitative model to work in all markets it must be robust enough to apply different factors to the different markets”.
A true global manager can exploit anomalies that occur as a result of the blinkered approach taken by regional specialists. Philips comments that the biggest opportunities come from exploiting these distortions and from using wider sources of information to cross-check management observations. For example, super-major oil companies enjoy a valuation premium in excess of strong European players like ENI and TotalFinaElf. A manager focused solely on US or UK stocks would not spot these opportunities. Equally, a manager in Japan might feel obliged to hold Toyota when it was trading extremely expensively on unrealistic expectations for its stake in telecoms company KDDI. A global manager can obtain pure auto stock exposure elsewhere. A stock may be listed in a domicile which does not reflect its earnings stream, for example Esprit, whose retail operations are mainly in Europe but which is listed in Hong Kong, which is cheap compared to European clothes retailers. The merger of Vodafone with Mannesmann meant that the market cap of the London shares rose proportionally, creating buying by UK-based funds. Had the merged group elected to list in Germany, an equivalent wave of selling would have resulted.
Not all consultants approve of an active global approach. For instance, Smith asserts that the lower risk proposition is to invest passively, commenting that no manager can possibly boast specialist local expertise in all markets.