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June 12, 1995 01:00 AM

MORE THREATS TO GLOBAL DIVERSIFICATION POP UP;ORGANIZED CRIME, REGIONAL AND ETHNIC CONFLICTS LEAD LIST

Mercedes M. Cardona
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    VANCOUVER, British Columbia - The need for global diversification remains strong, despite the recent strength of the U.S. markets, according to investment professionals at a recent conference.

    Overseas markets, particularly the emerging markets, still pose many hidden risks for investors in all asset classes, said speakers at the annual conference of the Association for Investment Management and Research. They noted that despite the recent strength in the U.S. equity market and the improvements in the domestic bond market, economic growth will be modest and investors should continue to look abroad.

    U.S. pension funds have increased the share of their assets invested overseas to 9% at the end of 1994 - up from 3% in 1988 - and it is expected to grow to 11.5% by 1998, said Abby Joseph Cohen, co-chair of Goldman Sachs' investment policy committee. Investors' confidence is high now, and many are going further out on the risk curve, including more international investment, said Ms. Cohen.

    One reason for that globalization has been a dramatic bear market on the dollar, which has bailed out many weak investments, said Ms. Cohen. She warned that if the dollar were to rise, the pace of diversification would slow as returns drop. Additionally, investors must watch their cash flows, she said, noting U.S. investors have placed similar amounts in the Japan and Hong Kong equity markets, even though the Japanese market is 12 times larger than Hong Kong.

    Fixed-income investors also have to deal with currency forecasting, which is out of sync with their bond forecasts, said Paul Burik, director of investment strategy at Commerz International Capital Management GmbH, Frankfurt.

    While bond forecasts tend to look at a six-month horizon, currency forecasts only look forward about three weeks, even though the total return on bonds is dominated by the currency, said Mr. Burik. Hedging the currency risk makes sense, but it would result in more modest returns, which creates a psychological barrier against adopting hedged positions, he said.

    "Currency forecasting is very tricky business. I'm not convinced anyone does it very well, which means making money consistently in non-base currency fixed income is difficult unless you have the wind on your back," said Mr. Burik.

    "It doesn't mean we shouldn't do it, it means our pencils will have to be sharper than before," said Ms. Cohen.

    An investment style focused on a top-down approach is a crucial requirement in international investment, said Marvin Zonis, professor of political science in the Graduate School of Business of the University of Chicago.

    With the end of the Cold War, new long-term concerns have risen to threaten globalization, said Mr. Zonis. A number of factors have replaced the Soviet threat, including regional and ethnic conflicts, such as those seen in the former Yugoslavia, Rwanda and Somalia; new diseases, as seen in the recent Ebola outbreak in Zaire; and the globalization of organized crime.

    The last factor is both the most serious and least publicized threat to economic globalization at the moment, said Mr. Zonis. Entire countries - most likely Italy, Russia and Mexico - are in danger of falling under the control of criminal enterprises, he said.

    Investors must look for a number of governmental and economic factors before making a commitment to a market, he said. They must look for signs of political stability; systems that protect private property within the country's legal code; a legal system that protects citizens from exploitation by the elites; a commitment from the government to control budget deficits; and a commitment to invest in human capital.

    In Eastern Europe, Poland has entrepreneurs that have figured out they can make money better in the production of goods, rather than trading in them, said Mr. Zonis. The Czech Republic is another country that has done everything right, joining a free trade area, which allows it to export its goods abroad.

    On the other hand, Hungary and Bulgaria have fallen under the control of former communist parties that are likely to spend more on welfare programs, threatening higher inflation and scaring off foreign investment.

    Mr. Zonis said he is cautiously optimistic about Russia, but warned investors should not put in more money than they can afford to lose. The outlook will depend in a large part on the outcome of the December election, he said, warning investors will flee if agrarian and xenophobic parties take control of the Parliament.

    Among the Latin American countries, Argentina and Chile meet most of the requirements for international investment, said Mr. Zonis. Argentina faced a scare with 1,000% inflation in 1989 that focused the government on controlling inflation. Chile, like the Czech Republic, has joined a free-trade area. Additionally, Brazil has potential because of its vast territory and resources, and its entrepreneurs have not faced inflationary scares of the magnitude of those in Argentina and Chile.

    Conversely, Mexico is mired in "corruption beyond the wildest dreams of anyone in the U.S. and Canada," and it is doubtful the government of President Ernesto Zedillo can regain control of the country, said Mr. Zonis. It is hard to be optimistic after the poor job Mr. Zedillo did handling the peso devaluation last December, he said.

    Mr. Zonis said he is very nervous about Japan, where business innovation is burdened by too much bureaucracy, and about many countries in Asia whose economies are closely linked with Japan. He said he also is leery of China, where there is no legal system to guarantee private property and a potential succession struggle within the government hints at future political instability.

    On the other hand, the Indian market is looking better after a downturn last year, although it still has to deal with issues of bureaucracy and corruption, said Mr. Zonis. The country has boosted its foreign exchange reserves and investment is up, but most importantly, India has a large middle class with discretionary income and human capital for development, he said.

    Some of the best emerging debt markets are the same countries that show promise in the equity market, such as Poland and Argentina, said Commerz International's Mr. Burik.

    Emerging market debt is a viable area and provides good return, but currency hedging is virtually impossible, so the investors must think in the very long term, said Mr. Burik. However, he added emerging market debt is less attractive for the U.S. investor than for non-U.S. investors, because the U.S. has a good supply of high-yield paper that doesn't carry the same sovereign risk.

    Direct investment in foreign countries also needs to be approached in a prudent, well-thought-out manner, said Gregory C. Wilkins, president of The Horsham Corp., a Toronto company making direct investments in South America. Investors need to have deep pockets and patience to wait for their investments to develop, and they need to know if and how they can convert the investment back into dollars.

    Investors need to look out for political instability, which can bring on the risk of expropriation without compensation, said Mr. Wilkins. Additionally, administration and taxation regulations can be more complicated overseas. He added investors must understand and accept that business moves at a different pace in other countries and must learn how relationships work in that culture.

    Successful international direct investors are companies that remain focused on the same strategy that made them successful at home, but adapt it to the overseas market, said Mr. Wilkins. The firms also need senior management and a board of directors with international experience and need to place a management team on-site that includes local personnel, he added.

    And sometimes, companies need the self-discipline to say no to some markets, he said.

    Managers will have to deal with the industry's ongoing evolution into a much larger global industry, said Charles Pictet, partner of Pictet & Cie., Geneva. Demographic forces - the aging of the industrialized countries' population and developing pension schemes in emerging countries - will cause pension fund assets to explode, he said.

    He quoted an InterSec Corp. forecast that estimates worldwide pension fund assets will grow 60% by 1999.

    As the variety of investment vehicles grows and sponsors deal with the resulting information overload, they will cope by breaking down portfolios into more specialized allocations, which will give managers less freedom, said Mr. Pictet.

    Firms will have to either specialize or internationalize, and knowledge of other cultures and languages will be a key factor for managers to survive, he said.

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