ASSET ALLOCATION TO ISRAEL: STRENGTHENING YOUR PORTFOLIO BY INCLUDING ISRAELI GLOBAL EQUITIES. May 2014

Transcription

1 ASSET ALLOCATION TO ISRAEL: STRENGTHENING YOUR PORTFOLIO BY INCLUDING ISRAELI GLOBAL EQUITIES May 2014

2 FOREWORD BlueStar Global Investors develops investment solutions and research on Israeli and Middle Eastern/Mediterranean markets and economies. This is our second BluePaper on a topic that is highly relevant to prospective investors in Israeli Equities. We provide an overview of asset allocation and diversification theory and practice and indicate how exposure to Israeli Global Equities via the BIGI benchmark can provide investors the potential for more efficient portfolios. Our conclusion supports a meaningful allocation to Israeli equities based on empirical risk- return calculations. Joshua Kaplan Research Associate Bruce Schoenfeld Director of Research Steven A. Schoenfeld Chief Investment Officer

3 INTRODUCTION Since BlueStar began discussions with investors early this decade about making a strategic allocation to Israeli equities, one of the most important issues we ve been asked to address is the potential contribution to portfolio returns and risk of single-market exposure. We have conducted numerous custom studies for foundations, endowments, investment advisors and consultants to assist their decision-making and highlight the potential of Israel s companies. With this research paper, we distill our research results and hope to stimulate further dialogue with prospective investors in Israel. Our conclusion supports the case for a dedicated allocation to Israeli equities. Just as sports teams arrive for their competitions with full squads and all of their equipment, world-class investors make sure their portfolios have all their players in the field and in the correct positions. How? By constructing their portfolios to achieve maximum performance, and optimizing them for the most reward for the least risk. The cornerstone piece of equipment for investors is diversification spreading risk among different assets so as not to have all your eggs in one basket. Diversification can be accomplished by mixing different asset classes (e.g. stocks and bonds) and within asset classes, by mixing different securities or choosing a mix of the same type of securities from different regions, countries, sizes or styles. In the most basic terms, a well-diversified portfolio is comprised of securities that are least correlated so that if one asset declines sharply in price, there is less of a chance that other assets will also decline sharply. In technical terms, the portfolio that maximizes the benefits of diversification is called the minimum variance portfolio. To continue with our sports analogy, different asset classes, when combined in the right mix, work like members of a well-conditioned and well-practiced team. This brings out the best in each team member and collectively minimizes the weaknesses of individual players. While most investors are familiar with the benefits of diversification and seek to structure their portfolios accordingly, much fewer take the concept to the next level - the point at which a portfolio is optimized to provide the highest expected returns at a specific level of expected risk. To achieve this, investors need to construct what is called an efficient frontier of possible assets, which ultimately determines the proper mix of investments to achieve those optimal returns. We will discuss the use of efficient frontier analysis in the context of integrating Israeli equities into investors portfolios later in this paper. Before doing so, however, we analyze the instruments available to get this exposure. ALL INDEXES ARE NOT CREATED EQUAL: ISRAEL S PLACE IN MAJOR GLOBAL EQUITY INDEXES A substantial amount of academic research supports the case for passive (i.e. index-based) rather than active investing. This research generally concludes that the low cost and diversification benefits of passive investing outweigh the benefits of stock picking, particularly over long investment horizons. 1 We therefore focus our analysis on the impact of adding exposure to Israeli equities in a global equity portfolio by using indexes to arrive at an optimized equity portfolio, an allocation that can be efficiently replicated using index-tracking funds. However, this analysis is equally relevant for investors who use actively managed funds the policy allocation is guided by index benchmarks, with implementation via active managers who aim to beat their respective benchmark. Well-constructed indexes (and index-based funds) provide significant diversification and risk-reward benefits, satisfying the needs of both the most sophisticated institutional investors as well as individual investors. Examples in the U.S. include the S&P 500, Russell 3000, and Wilshire 5000 indexes, each of which seeks to capture the returns of a broad slice of the U.S.-listed equity pie. At the global and international level, some of the most prominent indexes are those developed by the FTSE Group (FTSE) and MSCI, Inc. (MSCI). These include the FTSE All World and All World ex-us indexes and the MSCI All Country World Index (ACWI) and the ACWI ex-us. Common sense would suggest that since these indexes are generally looking to track the same universe of equities, their constituents would be the same. But, as each index provider utilizes its own index construction methodology, significant 1 For example, Jack Bogle, The Arithmetic of All- In Investment Expenses, Financial Analysts Journal, Volume 70, Number 1. 2

4 differences can emerge. The problem often can be traced to the overly rigid approach to country definition utilized in the creation of international and global benchmarking frameworks. The case of Israel provides a salient example of this. As shown in Table 1, the weight of Israel in these four major indexes differs from index provider to index provider. These differences range from 3 to 7 basis points (bps), which amounts to a calculation that the investable market capitalization of Israeli equities ranges from $57.2 billion - $69.8 billion (as of December 2013) While a variation of 3-7 bps may not seem substantial, it certainly is significant considering that trillions of dollars are invested in funds and portfolios that track these indexes. Table 1: Israel Equity Weight in Major Global Benchmarks Table 1: Israeli equity weight in major global equity indexes using MSCI and FTSE vs BlueStar index methodologies Source: BlueStar Indexes, as of Dec. 31, 2013 THE BLUESTAR ISRAEL GLOBAL INDEX (BIGI ): THE BETTER BENCHMARK FOR ISRAELI EQUITIES What if the calculations that go into arriving at the investable market capitalization in global benchmarks like EAFE are somehow flawed and result in a dramatic under representation of the true value of the Israeli equity universe? This is precisely the issue that has been addressed by the creation of BIGI, which is based on proprietary research and a methodology that is significantly more inclusive than that of either FTSE or MSCI as it includes Israeli equities whether they are listed in Tel Aviv, New York, London or even Warsaw. 2 Utilizing our fully inclusive approach, BlueStar has determined that the total market capitalization of Israeli equities was $220 billion (as of December 31, 2013) or over $100 billion more than the highest market capitalization calculation of other index providers. This missing market capitalization means that the four major global indexes cited above have 36 bps to 72 bps less exposure to Israeli equities than we believe is appropriate. When multiplied by the hundreds of billions of dollars invested in portfolios that track or are benchmarked to these indexes, the sums are quite substantial. TYING IT TOGETHER: ISRAELI EQUITIES IN A GLOBAL EQUITY PORTFOLIO In order to determine the impact of adding Israeli equities into a global equity portfolio BlueStar used as a starting point a fairly common equity allocation for U.S.-based investors: 70% U.S. equities and 30% international equities. As proxies we initially used the S&P 500, and MSCI s Europe, Australia and Far East (EAFE ) and Emerging Markets (EM) indexes as these are the most commonly used global benchmarks. For Israel exposure we used BIGI. In the graph below (Figure 1), we ve plotted the efficient frontier of portfolios consisting of just three assets, the MSCI EAFE index, MSCI EM index, and the BIGI. Each point on the graph represents a mix of assets that would correspond to historical standard deviation, a common measure of risk, and historical return on the x- and y- axis, respectively. The efficient frontier is the portion of the curve that connects the red diamonds. Each point along that portion of the curve is considered an efficient portfolio one that represents the least correlated combination of assets for any level of 2 See Appendix I for an overview of the proprietary BIGI index construction methodology. The BIGI methodology also results in an index that is broader and deeper than the local TA- 25 and TA- 100 benchmarks. 3

5 risk. Any point below and to the right of the efficient frontier represents an inefficient, and therefore less desirable, portfolio. It would be impossible to find a portfolio above and to the left of the efficient frontier unless other assets were introduced. The portion of the curve connecting the purple squares as well as the blue circles and orange triangle on the graph are included solely to illustrate the risk and return characteristics of various inefficient portfolios. The solid black line divides the graph into two halves around the lowest variance portfolio. For every point below that line for any given level of risk, there exists a combination of assets above that line with the same level of risk but better historical returns. Sophisticated investors are risk averse and think primarily in terms of the level of risk they are willing to bear for a certain level of returns. Take an investor who has identified that 18.25% historical annualized standard deviation is the maximum level of risk they could tolerate. That investor would find that many combinations of assets exhibit that desired risk level. However, only the combination of assets that lies on the efficient frontier would minimize expected correlations and maximum expected returns. For this investor, we illustrate one efficient and one inefficient portfolio that match that desired level of risk. The portfolio at the lowest point on the purple curve comprised of a 98% weighting in EAFE and a 2% allocation to BIGI - had a 7.5% annualized return over the previous ten years. However, if our notional investor simply draws a vertical line upward from that point, he or she would realize that by reducing EAFE s allocation to 51% and increasing BIGI s allocation to 49% they would have a more diversified portfolio that returned 10% annually over the past 10 years - or 2.5% more per year than the initial portfolio. This added return, which comes with no additional risk, is the famous free lunch described by Nobel Prize winner Harry Markowitz in his groundbreaking research on this topic. 3 For another example, consider an international equity portfolio consisting of 75% EAFE and 25% EM a frequently used international equity portfolio allocation between Developed and Emerging Market equities. That portfolio is represented by the orange triangle in the above chart. The minimum variance portfolio consisting of 76% EAFE and 24% BIGI has yielded roughly the same level of returns but with substantially lower risk. 3 See, Harry Markowitz, Portfolio Selection, in The Journal of Finance, Vol. 7, No. 1 March

6 A similar analysis can be done if we broaden the investment universe to include U.S. equities, represented by the S&P 500 index. The efficient frontier curve including U.S. stocks is displayed in Figure 2. A typical equity allocation for U.S. investors, represented by the orange circle is 70% S&P 500, 20% EAFE, and 10% EM. This combination of assets is clearly below and to the right of the efficient frontier curve and therefore sub-optimal compared to a portfolio using a different combination of assets. To determine what that asset mix is, the investor would simply draw a horizontal line from that point until it intersects with the efficient frontier. That portfolio, consisting of 56% S&P 500 and 44% BIGI, would return the 9.75% annually but with significantly lower risk. Thus another free lunch is potentially available to investors. Just like a good sports team, though, where the performance of even star players differs from year to year, the returns from individual assets in a properly constructed portfolio will also vary from year to year. In order to compensate for varied levels of performance, a coach will alter the playing time of his players accordingly. A good investor or portfolio manager will do the same and does so by systematically rebalancing the portfolio at pre-determined time intervals (in our study we use semi-annual periods) to make sure the desired asset mix is adhered to. The theoretical underpinnings for systematic rebalancing were provided by a seminal paper written by James Poterba and Lawrence Summers, which highlighted the additional benefits it provides by capturing mean reversion, the tendency of asset prices to overshoot in both upward and downward directions, ultimately returning to a mean or average level or trend. 4 In practical terms, rebalancing entails an annual or semi-annual exercise in which a certain amount of the best performing asset is sold and the proceeds are used to purchase additional units of the underperforming assets until the portfolio is rebalanced at the original target mix of assets. Although some investors rebalance their portfolios monthly, this can increase costs due to higher trading activity and typically produces inferior returns to similarly structured portfolios that are only rebalanced annually or semiannually. 5 Rebalancing ensures that the portfolio reaps the benefit of markets tendencies toward mean reversion, guards against human instinct to chase performance and also reduces a portfolio s volatility. 6 4 James M. Poterba and Lawrence H. Summers, Mean Reversion in Stock Prices: Evidence and Implications, in Journal of Financial Economics, Vol 22, pp , (1988) 5 Craig Israelden, The New Effective Frontier, in Journal of Indexes, March/April Steven Schoenfeld, Indexing at the Core, Chapter 30 in Active Index Investing, (Wiley Finance, 2004) p

7 CONCLUSION: INVESTING IN ISRAEL IS GOOD FOR YOUR PORTFOLIO To summarize, for those equity investors who are attracted to the concept of an allocation to Israel s dynamic corporate sector, an equity portfolio including Israeli global equities as measured by BIGI has the potential to provide investors with slightly higher returns and lower risk, based on historical performance. Even a small allocation to Israeli equities would have moved an investor s portfolio closer to the optimal portfolio located on the efficient frontier for any level of expected risk. As demonstrated above, those benefits namely higher returns at lower risk historically have increased as the allocation to Israeli equities rose. We are not suggesting that the typical investor allocate such a high percentage of their portfolio to Israel as the level we use in the above examples. In BlueStar s work with endowments, foundations and sophisticated individual investors since 2010, the range of allocations to Israeli Global Equities (with BIGI as the benchmark) has ranged from 2% - 4% of global (all country) portfolios and 6% - 10% of international portfolios. Each investor s investment objective and level of risk tolerance is unique to their particular circumstances. However, the evidence presented in this paper clearly indicates that even a relatively small weighting in Israeli Global Equities can enhance portfolio returns without increasing portfolio risk. Israel is undoubtedly a player you want on your investment team. 6

8 Sample Portfolios with Varying Degrees of an Israel Equity Overweight and Semiannual Rebalancing (Initial Portfolio Weights Based on Efficient Frontier Charts Figures 1& 2) All-World Portfolios Consisting of S&P 500, MSCI EAFE, MSCI EM and BIGI International Portfolios Consisting of MSCI EAFE, MSCI EM, and BIGI 7

9 APPENDIX I: Methodology for the BlueStar Israel Global Index (BIGI ) For a complete list of BIGI constituents, sector weights, as well as the full Methodology Guide, and historical performance, see 8

10 APPENDIX II: BIGI Benchmark Characteristics Israel Benchmark Index Sector Exposure Source: BlueStar Global Investors LLC Dec. 31, 2013 Israel Benchmark Concentration Ratio Source: BlueStar Global Investors LLC Dec. 31, 2013 BIGI vs. Global and US Benchmarks: Long- Term Total Returns Source: BlueStar Global Investors LLC Dec. 31,

11 BIGI vs. Global and US Benchmarks: Long-Term Risk * Source: BlueStar Global Investors LLC Dec. 31, 2013 BIGI vs. Global and US Benchmarks: Five- Year Correlations Source: BlueStar Global Investors LLC Dec. 31,

12 BLUESTAR GLOBAL INVESTORS LLC 1350 AVENUE OF THE AMERICAS 4TH FLOOR NEW YORK, NY BlueStar Global Investors LLC and BlueStar Indexes make no warranty, express or implied, as to the results to be obtained by any person or entity from the use of the index, trading based on the index, its suitability or any data included therein in connection with the trading of ETFs tracking BlueStar Indexes ETFs,, or for any other use, or in connection with any other product mentioned in this document. The information contained herein is not intended as a recommendation to buy or sell any security and past performance is no guarantee of future results. BIGI, BlueStar Indexes, BlueStar Israel Global Indexes, and BluePaper, are trademarks of BlueStar Global Investors, LLC BlueStar Global Investors, LLC 11