Global equity investments grow more popular

The traditional practice of separating domestic and non-domestic equity portfolios is facing substantial challenges. This approach limits the range of investment choices and reduces flexibility for investment managers at a time when the opportunities are broader than ever.

A global equity mandate, by contrast, enables the investment manager to cross borders between emerging and developed countries and between market capitalization ranges. It also facilitates analysis and comparisons between companies in similar sectors around the globe, contributing to more astute decision-making.

The move toward global equity mandates in the U.S. has been slow, but the pace is starting to accelerate. In the U.K., since the traditional balanced management structure began to weaken in the middle of the last decade, institutional investors have embarked on a major shift toward global equity exposure. The same phenomenon is now starting to occur in continental Europe and Asia.

A performance analysis of U.S. and non-U.S. equity markets over the past three decades clearly demonstrates the rationale for investing globally. Non-U.S. equities have typically reduced total portfolio volatility, even if they have not always matched the returns of U.S. equities (see Figure 1).

In the 1970s, non-U.S. equities demonstrated higher returns and lower volatility, while the 1980s also saw good returns but higher volatility. In the 1990s, a non-U.S. allocation achieved lower volatility but returns suffered by comparison with the U.S., thanks largely to the underperformance of Japan. At the same time, correlations between U.S. and non-U.S. markets have been steadily rising, exceeding 0.8 by the end of 2003 compared to the long-term average of around 0.6 (see Figure 2).

At least two factors are driving this phenomenon. First, the development of global industries, such as telecommunications and information technology, pushed correlations dramatically higher in 1998 and 1999, and they have remained high as the technology, media and telecom bubble deflated global stock prices in this sector. Second, the establishment of the euro and a unified monetary policy has driven correlations higher across European markets.

Over time, global correlations have displayed a cyclical pattern, and they may well revert to their long-term average. But there are reasons to believe that both sector and country correlations could remain well above their averages. In addition to the integration of Europe, there have been important developments in international trade and in the globalization of business practices. The number of global trade agreements such as the North American Free Trade Agreement is increasing and transportation is becoming cheaper and faster. Information flow is greater and accounting standards are being harmonized.

For the last decade or more, plan sponsors generally have been less comfortable with global approaches. Money management has become more specialized with "experts" in various subsets of the investment arena. Consultants have produced scores of studies showing that skillful asset allocation can drive the overall performance of a total portfolio, and plan sponsors have become more comfortable with a top-down/macro decision-making process that brings this asset allocation decision in-house.

While most attribution methodologies focus on top-down decisions as the "driver" of performance, with stock selection becoming the residual to any value added, a well-executed global approach requires a manager who can successfully identify undervalued securities or industries from the largest possible field of opportunity. As long as a plan sponsor does not define risk as "deviation from a benchmark," we believe a global approach to research and investment is increasingly the best course.

Several factors support this argument:

More opportunity: Using the Morgan Stanley Capital International All-Country World index as the proxy for the world market as of Dec. 31, 2004, North America only accounts for 52% of world market capitalization totaling $21 trillion, leaving Europe with almost 30% and Asia, 13%. Outside North America, the relative importance of Japan has declined over the past decade while emerging markets have raised their profile, further broadening the array of choices for investors.

In investment terms, a global equity mandate offers access to a broad range of leading companies with large market capitalization and good growth prospects. According to I/B/E/S Estimates and Factset as of April 15, there are about 4,500 companies around the world capitalized at $1 billion or more, of which about 57% are based outside the United States.

Global research: Many large investment firms have reshaped their research units to focus on global sectors. Instead of having sector analysts focus on specific geographic regions, research is being organized around global economic or industrial sectors, with a regional overlay. Analysts are comparing companies in specific industry sectors around the globe and developing longer-term financial models to facilitate comparisons among companies in similar industries. This information is supplemented by regional economic and political analysis.

Global accounting standards: The drive toward uniform standards has been slow and marked by disagreement between the United States and other countries. But progress is being made and it is only a matter of time before accounting standards are harmonized across borders in the developed world.

Emerging market equities now form a significant part of the global opportunity set. The fundamental case for this asset class is based on high economic growth combined with valuations that are not far off historic lows, despite recent strong performance. Gross domestic product growth in developing countries is almost double that of developed markets, and this trend is likely to continue.

China, where per-capita GDP more than doubled in the 1990s, is the obvious example. In the current decade, China's per-capita GDP is expected to rise even further. Going forward, the admission last year of several central European countries such as Poland and the Czech Republic to the European Union promises to boost economic growth in that region as well.

Other factors working in favor of emerging markets are:

Low correlations: Historically, emerging and developed market correlations have moved in different directions. Over the past 10 years, the average three-month rolling correlation between emerging market and U.S. equities was around 0.67 while the correlation with Europe was slightly lower at 0.56. Furthermore, emerging markets tend to have low correlations with each other.

Reduced volatility: Historically, emerging markets have been volatile compared with developed countries, but this is primarily an individual country or regional phenomenon, not a characteristic of the asset class in general. Volatility in these markets is also less pronounced than just a few years ago.

Improving corporate governance: Many companies are moving independently to adopt U.S.-style corporate governance standards and governments are enhancing regulatory frameworks with a view to attracting and retaining foreign investors.

A key advantage of a global equity portfolio is its flexibility to move opportunistically among regions, countries and sectors, whereas switching between separately managed U.S. and non-U.S. portfolios requires a tactical decision that might be difficult and time-consuming to make.

A global approach may also reduce turnover in the portfolio resulting from the need to rebalance if a strict top-down asset allocation method were adopted. Further, a global portfolio will almost certainly have exposure to the U.S., the largest component of world market capitalization.

The importance of regions to overall investment returns has varied significantly over time. In the past two decades, a strategy of investing in those regions that had outperformed in the previous five years would not have achieved much success. From 1984 to 1988, for example, Japan was the best performing market, followed by Europe, in terms of annualized dollar returns. But from 1989 to 1993, Japan was the worst performing region and Latin America took the lead.

In recent years, sector influences have largely surpassed both regional and country factors in the asset allocation decision. While all three are subject to cyclical trends, global equity returns have increasingly been driven by sector exposure.

Part of a plan sponsor's decision on how much to allocate to a global mandate should reflect where a plan's liabilities are located. If a currency overlay can be used to hedge overall assets back into the base currency to remove this risk, then in theory 100% of equities should be global, allowing the most opportunity for absolute returns and the identification of value wherever that may be.

Clearly, however, most plan sponsors would not be comfortable with such an allocation and would prefer to retain at least some of the asset allocation decision in-house. Depending on a variety of factors, including the sponsor's country of origin, an allocation of between 20% and 25% of total equity assets to a global mandate might be a more likely starting point. This allocation, of course, depends on the unique situation of each sponsor.