Portfolios for a changing world

Australian Financial Review, April 2008

It’s a changing world. Who would have thought 20 years ago that by 2007, China would be the world’s second largest economy by purchasing power parity, and India the fourth? But you wouldn’t really know the world has changed by looking at the portfolios of many global equity funds run from Australia.

Many funds measure themselves against the MSCI World ex-Australia benchmark, or some similar variation. This index is made up of 52.8% North America (48.43% of it the USA), 24.5% Europe ex the UK, 10.9% the UK, 10.1% Japan, and just 1.7% the Pacific ex-Japan (including Asia). China and India don’t get a look in. Active funds who follow the benchmark obviously don’t have to match this exactly, but they generally stay pretty close to it. The index is a reflection of the size of world stock markets, and it considers only 23 countries, which MSCI considers to be developed.

But is that still a suitable way to get your exposure to world equities? The question is particularly pertinent as the US slips into either recession or slowdown, depending on which economist you believe. Surely this is not the time to be putting more than half of your money into North America?

More and more managers think this is getting the process all wrong. In this feature, we speak to several of them – and then put the case for the defence.

“I’m not a ‘deviating from the benchmark by 1 or 2%’ type of guy – that’s a 20^th century way of investing,” says Clay Carter at Perennial Investments, who runs the Perennial Global Shares High Alpha Trust, which ignore benchmarks. “With globalisation and the blurring we’re seeing between the developed and developed world, there’s no such thing as emerging markets,” he says, excepting real frontier markets like Vietnam. “Brazil, Mexico… they’ve already emerged. From a global investment standpoint you have to accept that reality and say: what is the world going to look like in the 21^st century? And the US is not going to be where half of all the opportunities are.”

At Five Oceans Asset Management, chief investment officer Chris Selth accepts that benchmarks are part of life. “We are aware that benchmarks are going to be used by a lot of consultants and investors as reference points: how my investment is doing relative to the market.” But that doesn’t mean you have to invest in line with them. “In order to beat the market, the best way to do it is not to look at the markets. You look at underlying businesses, with high conviction stock work, building a diversified portfolio across a range of industries and geographies. Over time, that will generate performance which will beat benchmarks.”

Platinum Asset Management is a well-known example of a fund manager that shuns benchmarks. “We don’t think the index represents a sensible starting point particularly,” says Andrew Clifford, deputy chief investment officer and manager of the Platinum Asia Fund. “It’s a measure of the biggest companies, not necessarily the best opportunities. The US is 25% of world economic activity but more than 45% of the markets, whereas Asia, which is a larger part of the world economy if you include Japan, is less than 20% of world markets. So the index doesn’t reflect where economic activity is occurring, and certainly not where the most interesting opportunities are  – Asia.”

One problem with mirroring the MSCI is that it draws you into the markets that have already grown and performed, chiefly the USA. “The perversity is, the maximum exposure you have to an area is at the end of its bull run,” says Clifford. Your maximum investment in a stock like Cisco would have been at the top of the tech boom. Today it is about 70% off its highs; you would have a quarter to a fifth of the investment in it compared to at the top. That doesn’t make sense, fundamentally.”

Another issue about the MSCI index, and others like it, is that it doesn’t really reflect the changing nature of corporate behaviour. Companies have gone global and their physical head office location doesn’t really make a big difference. Perpetual Investments, for example, which also builds its international portfolios without reference to a benchmark, holds the German automobile manufacturer BMW – but one of the main reasons it does so is because of BMW’s exposure to the Asian region. “They sell more in Asia than in Germany,” says Emilio Gonzalez, who heads the international business. Through that selection and others like them, Perpetual has a higher exposure to Asia than its allocation would initially suggest.

Selth agrees. “If you talk about indices you need to deconstruct them between global stocks and domestic stocks,” he says. “Emerson Electric is an American-based electrical engineer, but involved in refitting plants globally, with a strong Asian bias. Nokia is based in Finland, but its biggest sales are in China and India.” The Five Oceans World Fund holds both stocks. “These index numbers mask an important truth of the market: is this company exposed to the US consumer and financial cycle, or to the world, or to Asia?”

A look at these four managers portfolios show some interesting things about geography. Although none of them base their allocations on the merit of a particular country, almost all of them end up underweight the US based on their policy of picking the best stocks wherever they are in world. They also end up with wildly different allocations. In Platinum’s global fund, for example, the exposure is roughly 24% to North America, and with particular focus to individual sectors such as the paper industry. It has 19% in Asia and a further 21% in Japan.  On March 31 Five Oceans had just 8.81% exposure to the US, and 10.2% to Europe, but even less than the benchmark in Asia – just 0.59%. (Most of its money at the moment is in cash and forwards.) And at Perennial, the stand-out allocation is Latin America, accounting for about 20% of the fund.

In all of these cases the geographical allocation is accidental – it’s a consequence of particular stock or sector selections, and the geographical split falls out of that. Curiously Perpetual, despite not tracking a benchmark, has ended up with an allocation very close to it – the US about 45%, Europe 33.4%, Asia just 1.05%, UK 7.85% and Japan 9.92%. It’s not always been like this – in the early 90s the same team was heavily underweight Japan, for example – but it is interesting to find that these are the areas they find value. Reiterating the earlier point of global stocks and their essentially irrelevant places of domicile, Gonzalez says the US allocation is “not a call on the US economy, or the US cycle necessarily.”

On the face of it, it’s a no-brainer to shift money away from a flagging US economy to vibrant emerging ones. In April, it was announced that China’s first quarter GDP growth had fallen – to 10.6%! Compare that with the USA, where real GDP growth is expected to be 0.8% this year. Asia has a vast and growing middle class, driving consumer spending; its financial sector is in good shape, with few banks having meddled with sub-prime; companies, by and large, learned the lessons of the 1997-8 financial crisis and are reasonably low on debt; and increasing intra-Asian trade (debatably) reduces the impact of a US slowdown on the region.

A few counterpoints are worth considering, though. One is that a fund manager who bailed out of America at the start of the year and pushed into Asia, recognising the coming slowdown in the US and the relentless growth drivers of Asia, would actually be worse off today. The US S&P 500 index was down only 7.9% in the year to April 16; Hong Kong was down 14.1%, India 19.9% and China 33%. “We wholly concur that Asia is certainly the growth diver of the world, but that doesn’t necessarily mean you always want to be overweight Asia,” says Selth.

Another is that the MSCI is intended as a guide to developed markets, with international standards of governance and transparency. Many Asian or Latin American markets are exciting and offer great opportunities, but they come with risk too. “With any investment decision, there’s two sides to it: risk and return,” says Gonzalez. “Emerging markets have growth rates that the developed world is chewing at the bit to achieve. But at the same time the risks are higher.” That’s one of the reasons Perpetual gets Asian exposure through international companies listed elsewhere and governed by accounting and regulatory frameworks the fund manager is comfortable with.

Thirdly, emerging markets are not easy to access. In a sense, it would be ridiculous for the MSCI index to include China, because Chinese stocks by and large cannot be bought by foreigners. (The exceptions are Chinese companies listed elsewhere, chiefly Hong Kong; Hong Kong represents 1.09% of the MSCI World ex-Australia index). Places like India and Malaysia do not have fully convertible currencies, which makes it trickier for investors to repatriate products.

In any event, there are reasons that some managers do track benchmarks, and they start with consultants and institutions. Trustees of big institutions like super funds are nervous about tracking error – that is, the degree of variance away from predictable returns like the broader market – because they have a strict responsibility to manage their members’ assets prudently and safely. “When you take the absolute return route [that is, ignoring benchmarks] you end up with a higher tracking error… you can be seduced into thinking that high tracking error means higher risk, although it doesn’t necessarily mean that,” says Carter. Consultants, who serve that market, tend to take a similar level of conservatism. “A lot of big pension plans and consultants have been using these benchmarks for so long they’re ingrained, basically,” Carter says. This policy leads large amounts of any given international equities mandate to the US.

Deviating a long way from the benchmark carries risks, too. “From time to time, things come out of nowhere and strike the market or a particular stock, which is always difficult to see coming,” says Clifford. “The risk is, if you take a big position away from the benchmark and get hit with one of those, your historical performance is all important and your business will be substantially hit by that. I don’t think it’s easy for the industry to get away from managing against the index.

“In recent years lots of independent managers have broken away from the bigger institutions” and set up benchmark-averse approaches like Platinum “but it’s very hard for them to do that in a standard large corporate environment.”

And the fact is, everybody wants their investments to be measured against something – that’s only natural. How else can they evaluate performance? One mooted model is a peer group composite, but as Rob Nunley, an Asia specialist at Five Oceans, points out, that’s full of problems too. In Asia alone, there are people who manage Asia ex-Japan funds, Asia with Japan, Asia with Australia, Far East excluding India, and so on. “Going down that road is possibly even more fraught than indices,” he says.

One approach that pension funds increasingly appear to be taking is to get the exposure of the markets through an index fund, and then take up some benchmark-free, active funds around the edges. This is known as core-satellite. It is also sometimes referred to as portable alpha: getting the beta (market return) through the cheapest possible means like an index fund, and the alpha (outperformance) separately.

This supports benchmark-averse global equity managers, and also country or region-specific funds looking at distinct parts of the world. Morningstar lists 42 distinct Australia investment trusts focusing on Asia ex-Japan, either as a region or individual countries like China and India. (Tellingly, there are only three-year performance numbers available for 23 of them: the rest are all too new). They have all been smashed recently – the median six month performance is a 16.58% loss – but they represent a way of getting more focused emerging market exposure for those who want it.

 For the moment, most funds are likely to keep putting a lot of Australians’ money into the US just as it heads into possible recession. As always, how they fare is going to depend on manager skill.

BOX: DOES IT WORK?

More and more managers are abandoning benchmark weights and putting more money into emerging markets, at the expense of the US. But here’s the salient question: does ignoring the benchmark work?

Let’s take a look at the performance numbers for overseas share funds from Mercer Investment Consulting up to March 31. Mercer divides these funds into growth, value, index and core-styled products; since it’s the biggest chunk, we’ll look at core.

Over three years, the top performers are Zurich International Equities, Deutsche Global Thematic, Fidelity Global Equities, Fidelity Select Global Equities, and Merrill Lynch Wholesale International Shares.

The Zurich fund measures itself against the MSCI benchmark, and its mandate is to outperform it, but its approach is thematic – based more on sectors than geography. “Consequently, the stock selection process is not tied to traditional benchmarks,” says Zurich. The Deutsche fund styles itself
“on the belief that there is one global economy and the best investment ideas know no national boundaries… the country allocation is a residual of the thematic approach.” Like the Zurich fund, it measures itself against the MSCI, but doesn’t have to follow its geographical approach. In practice, as of March 31, the fund was heavily underweight North America, with 25.41% of the holdings there; Europe had 41.69%, Asia ex Japan 14.76%, Latin America 10.32%, Japan just 3.22% and the Middle East and Africa 1.17%.

The Fidelity Global Equities product says it has a “go anywhere mandate” but its allocations do look broadly similar to the MSCI index, albeit with a heavy US and Japan underweight. On March 31 it had 32.3% of its money in the USA plus 2.7% Canada, 11.8% in the UK, 3.9% in Japan, 18.8% between Germany, Switzerland and Spain, 5.5% in Australia, 8% in cash and 17.2% in ‘other’, which presumably includes allocations to Asia, the rest of Europe and possibly Latin America. The Fidelity Select Fund, however, has “strict regional and industry controls,” and tracks the MSCI index very closely: 47.1% USA, 11.1% UK, 9.8% Japan,4.2% Canada, 17.3% among major European nations, 2.3% cash and 8.2% “other”. And the Merrill fund is managed against global sector rather than country convictions.

In short, funds that both do and don’t track geographical allocations have done well. Funds that both do and don’t put large chunks of their funds into the North American markets have achieved good returns. That appears to demonstrate that manager skill can find good opportunities in any market.