The evolution to international from domestic equity portfolio management has followed a thoroughly plausible and reasonable course.
The average domestic equity manager does not try to time the market; cash is an annoying residual. The domestic manager holds sufficient numbers of stocks to ensure a broad exposure to the market. The manager selects stocks by considering their relative attractiveness within respective industry sectors and weights industry sector exposures to reflect his view of the economy. He may, in token acknowledgement to quantitative theory, determine market exposure to ensure he is not leveraged and tracking error to ensure he is not taking on too much individual stock risk.
International equity portfolio management has simply followed the domestic approach. Each country or geographic region is managed by a local equity specialist. Foreign currency is a nuisance; thus, by extension, currency hedging is ignored by this local specialist manager. Sufficient stocks are held to represent, at least loosely, each foreign market. The key local industry sectors are represented by favored stocks and weighted to reflect the specialist's view of the local economy. He may use a risk model to determine the portfolio's exposure to each foreign market and the aggregate individual stock risk.
Plausible, reasonable, widely accepted and replicated in global fund management firms in London, New York, Tokyo and beyond ... and a million miles from the best way of thinking about and managing international equity portfolios.
The investment community agrees that asset allocation in the international equity arena is the major challenge. How do you decide whether to transfer assets from France to Australia when your European and Australian experts both are raging bulls? Even worse, as the global strategist, you have this nagging fear that European and Australian equity mangers are operating from different assumptions about the state of the global economy, and this is affecting both their market views and their stock selections. You also may have little or no handle on your global exposures to economic sectors, nor any real feel about your risk with respect to your benchmark.
Employing a global risk model provides some guidance. Operating at the market index level, it gives you an idea of how risky your portfolio would be if you held the index in each market, but with allocation weights corresponding to your actual allocation. It can help by identifying where your market allocation risk is concentrated. But how many global active manager portfolios hold even approximately an index funds in each market?
Edward Fishwick, head of research at Quantec Ltd., in collaboration with Andre Perold, professor at the Harvard Business School, set out more than a year ago to review the process of international investment management from scratch. With the key objective of developing new investment technology to enable a global equity strategist to manage local portfolio managers in a systematic fashion, this study also sought to answer some key questions:
Are there global industry sectors?
Why are equity markets so highly correlated?
Is it sensible to assume Imperial Chemical Industries is best characterized as being part of only the U.K. equity market?
Is it sensible to deem British Petroleum to be unaffected by movements in exchange rates?
Is the exposure of an international equity portfolio to the deutsche mark perfectly characterized by the value of the German equity portfolio as a percentage of the total fund?
Is the combination of largely independent local equity managers likely to be efficient?
Are there global industry sectors?
Many studies have concluded there is some evidence for a global oil sector, but evidence for other global industry groupings is inconclusive. But speak to any senior industrialist in a multinational company, and he will tell you that of course he is worried about what his American, Japanese and European competitors are up to.
Why this gap between academia and the real world?
Because the academics are simply looking for global industry effects in the wrong place. Consider the conventional way of thinking about global equities. Each country is looked after by a local specialist, and the first thing the specialist does is focus on the local market. Thus when the academic looks for global industry effects, he looks at the stock returns that are left after local market returns have been removed. He finds little evidence of global industry sectors. Why? The global industry returns have been hidden in the local market returns. What is the "return to FTSE" but principally a combination of just those global industry sector returns for which the academics are looking?
Our research shows there are eight unambiguous industry sectors - energy, utilities, transport, consumer, capital, resources, basic industry and financial. This ties up with the industrialist's expectations. Each company's exposure to each industry sector is tested for significance, and the larger companies are often found to be exposed to more than one global industry. Furthermore, these exposures are intuitively those one might expect from analysis of a given company's fundamental data.
Why the high correlation?
The common dependence of similar economies on a similar group of these global industry sectors means their equity market returns also are closely related to the returns of the appropriate industry sectors. Thus, for example, Canada and Australia's economies both are heavily exposed to the raw material-intensive sectors (oils, mining, etc.), and their equity market returns can be largely explained by reference to the returns from these same global industry groupings. Thus, their total market returns are strongly correlated. Similarly France and Germany, whose stock markets are dominated by companies with similar industry sector exposures, also are correlated through these common global industry sector effects.
When, on the other hand, you consider local market returns net of the global industry effects, you observe raw returns representing purely local economic policy and local investor sentiment. Thus correlation between truly local markets are found to very low, as would have been expected.
ICI: Only part of the U.K. market?
Our research determines first that ICI has significant exposure to more than one of our global industry sectors. We then extend our analysis to look at ICI's significant exposure to truly local markets, net of these global industry sector effects. And, lo and behold, just as we might have expected, ICI is significantly exposed to the United States and Germany, as well as to the United Kingdom. A solely U.K. characterization is a significantly sub-optimal model of ICI, as obviously would be the case to any industry analyst. However, of course, most brokers and fund managers continue to analyze ICI in primarily solely the U.K. context.
BP unaffected by exchange rates?
BP, like ICI, traditionally is analyzed by the domestic U.K. specialist management team. Foreign currency exposure, if it is considered at all, is considered in one dimension, i.e., exposure to foreign earnings. But clearly, not all foreign earnings are alike. Exposure to dollar earnings is simply not the same as exposure to yen earnings.
Having characterized BP in terms of its significant global industry exposures, and in terms of its significant exposures to the truly local markets, we finally identify its net exposure to the major currency blocks. Not only do we find that adding currency into the approach significantly increases our ability to explain equity returns, but we discover it is important to add currency in the three key dimensions (U.S. dollar, yen and deutsche mark). This result would be unsurprising to any bond or currency manager.
Thus BP is affected significantly by its exposure both to the U.S. dollar and to the deutsche mark, and that exposure is pretty constant over time.
The real exposure to the mark
We now can extend our approach to the global equity portfolio. We strip out global industry exposures, local market exposures and, finally, an explicit set of currency exposures. These are the currency exposures one might consider hedging in the forward markets. Surprise, surprise, we find it simply is not the case that the value of your German equities determines your exposure to the deutsche mark. Because some of the German equities have exposure to other currencies, and some of the other countries' equities have exposure to the deutsche mark, it is not always the case that the mark exposure is less than you might expect on a simpler but more naive analysis, but this is often the case.
Clearly, for hedging, the issue is exposures relative to the benchmark. The approach enables us to characterize the currency exposure of the benchmark (e.g. Morgan Stanley Capital International Europe Australasia Far East Index) and of your portfolio, to calculate the difference, and determine hedgable exposures on which a currency manager might be asked to focus. It is obviously dumb to get an overlay manager to hedge out an apparent currency bet that turns out, in fact, to only be part of a carefully chosen global industry bet by the global equity managers.
Efficiency of local managers
Our analysis shows using largely independent local equity managers unambiguously to be inefficient, and, we would predict, this old-fashioned approach increasingly will be seen to be obsolete over time. In the mid-'80s, it was reasonable to look at local markets in isolation. In the mid-'90s, globalization of the world's equities means this is clearly not the best approach.
The new approach will involve an explicit recognition of these global industry sectors and their increasing importance. Local market economic and sentiment effects will be given their relevant place in equity return prediction. Currency will be able to be managed in an appropriate fashion, with net currency exposures properly identified.
Equity fund management departments will be organized along global industry sector lines, with specialist departments looking at the truly local industry groups and the smaller domestic companies. However, the vast bulk of those companies typically held in institutional portfolios will be recognized as having significant exposure to one or more global industry sectors. Return predictions will be made for each of these global industry sectors. Local market specialists will focus on local monetary policy and sentiment issues, and will feed their return forecasts to the strategist. Currency projections will again be made explicitly. Within this highly structured and disciplined framework, the stock pickers can operate confidently within the favored sectors on screened candidate lists that reflect favored global industry sectors and local market economic conditions and sentiment. Finally, currency risk can be explicitly and professionally managed.
The strategist will at long last be able to be confident that the global portfolio reflects the house's global economic judgments. The allocation between global industry sectors (something the strategist understands) can be managed explicitly, as can the exposure to local market conditions, and currency can be dealt with efficiently. Risk and return can be measured and attributed correctly to the various factors (global industry, local market and currency) to which the portfolio is explicitly exposed.
We have examined the impact of the new approach on the global (or international) equity fund management business. But what about other related businesses?
The domestic manager will benefit from this new-found knowledge. At long last, for example, for a U.K. pension fund, the manager will be able to integrate the 55% U.K. equity exposure with the 25% international exposure. The manager will know the domestic portfolio's exposure to the global industries, to other markets (remember ICI) as well as to the local one, and also will be able to measure (and control if desired) the currency risks embedded in the portfolio of domestic stocks, which can now be viewed, in line with reality, as a global portfolio of exposures.
The sell-side analyst will have a clear framework within which to place stock research. The more forward-looking broking houses will continue the trend of rearrangement into global industry groups, rather than domestic introverted analysis.
Finally, the structured desk of an investment bank will have a means of pricing an over-the-counter option on an international basket of stocks that accurately reflects their true composition, rather than simply guessing they might represent a set of local market indexes, that are deemed to be loosely correlated.
The new hierarchy of global industry sectors, true local market effects, and net currency exposure progressively will replace the inefficient old-fashioned hierarchy of local markets, followed by some nodding acknowledgement of the impact of industry and currency. It is hardly surprising: The old hierarchy grew up by historical accident, only adequately representing the globally immature world that faced us in the mid-1980s. The new approach is the only way to handle the increasingly complex global interrelationships implied by the improved communications, cooperative political environment, and enlightened trade legislation that faces us today.
Bruce Pullman is head of investment management consulting, Quantec Ltd., London.