The Advantages of International Equity Portfolio Management
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- Joella Henderson
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1 L1 A smarter approach to international equity investing Before the era of globalization, the rationale for investing in international stocks was pretty simple. The U.S. was the major world market, but it wasn t the only world market. A properly diversified portfolio needed exposure to non-u.s. growth opportunities, too. But today, while international diversification is arguably more important than ever, the path to that goal is not as straightforward as it once was. Geographical diversification alone is no longer sufficient, because so many companies rely on a global customer base. A smarter approach to international equities needs to factor in three key considerations: Equities are an important part of a core portfolio. But in a period of volatility and slow growth, investors should expect equity allocations to address more than just capital appreciation potential. John T. Hailer President & Chief Executive Officer, The Americas and Asia, Natixis Global Asset Management 1. The desired role of international equity in a diversified portfolio 2. How globalization has changed basic assumptions about international investing 3. Different ways to address the risks specific to international equities Understanding how these elements affect a portfolio may make it easier to choose between competing international equity managers.
2 The role of international equities in portfolio construction Investing in international equities can improve diversification for U.S. investors and may offer additional opportunities for return, but it also introduces political, economic, currency and country-specific risks. Understanding the risks and opportunities associated with different styles of international equity management can help ensure that an international fund may fulfill the desired role in portfolio construction. International allocations are most often used to enhance or provide new sources of return, but there are also actively managed funds designed to moderate overall portfolio risk. Perhaps more important, certain characteristics of international equities may also increase the potential for low or non-correlated returns, which can improve overall diversification. Quantifying the opportunities Before selecting an international fund, investors need to have a clear understanding of its risk and return dynamics, specifically: How the manager deals with the particular risks associated with international investing How the manager seeks to generate returns Some questions to ask in this evaluation process include: Are the sector allocations restricted to ranges around an index? Managers constrained by sector weights may be more likely to deliver performance that mimics the benchmark. Managers without sector guidelines have more leeway to over- or underperform. Understanding the manager s approach and skill level can help determine whether the fund should be considered a return-enhancing or a risk-reducing allocation. Are the country/regional allocations tied to ranges around an index? Similar to sector allocations, funds that maintain geographical exposures that mirror the benchmark are more likely to produce index-like returns. Are the currency exposures hedged? Currencies can be a big driver of returns. Knowing if an international manager approaches currencies strategically (long-term view) or tactically (short-term view) can shed light on how currency fluctuations will affect returns. Strategic managers may believe that currency differences even out over time, while tactical managers may be more likely to try to smooth the currency impact with hedging. Does the fund invest in emerging markets? Is there a limit? The high growth expectations associated with emerging markets have plenty of allure, but being able to capture that growth through the stock market may not always be easy. The level of exposure to emerging markets can affect both volatility and returns. How concentrated is the fund s portfolio? The international markets offer tens of thousands of companies to choose from, and some managers own hundreds of names to participate in these opportunities. Others prefer to run concentrated portfolios that rely more on security selection. Broadly diversified portfolios are more likely to look and behave like the benchmark. Concentrated funds may mirror the benchmark with sector or country weights, but perform very differently. Are there any volatility, beta or tracking error targets? Given the variety of variables that can affect international equity markets, their volatility can be higher than in other asset classes. A fund that uses some type of volatility target may have a more predictable risk profile than one that does not. Is the portfolio actively or passively managed? Passive index investing provides exposure to hundreds of companies, making it difficult to isolate the specific exposures an investor may want. Active managers generally try to target particular exposures, which could either increase or decrease the risk profile depending on the fund s objective. All of these elements factor into the expected risk and return an international allocation will deliver in both absolute and relative terms. Depending on the risk exposures taken elsewhere in the overall portfolio, some characteristics are more important than others. For example, in a portfolio based around more conservative core holdings, a concentrated emerging markets allocation could provide a welcome source of alpha potential. But the same fund may not be suitable for a portfolio focused more explicitly on managing volatility. In that case, a more broadly diversified, actively risk-managed fund might be a better choice. 2
3 Globalization and today s international equity markets Once the role of the allocation has been determined, the task is to find an appropriate international fund to play the part. But globalization has changed the dynamics of international equity investing: what you see isn t always what you get. For example, years ago, most American companies earned the bulk of their profits from sales in the U.S., and most international companies revenues were linked to sales in their own countries. Today, that s no longer the case. As of December 31, 2011, only about half the revenues of the 30 companies in the Dow Jones Industrial Average came from the U.S. (Figure 1). Consider these extremes: Intel received only 21% of its sales from the United States; for AT&T and Verizon it was virtually 100%. Similarly, Coca-Cola and McDonald's are considered blue-chip American companies but neither of them earns more than 33% from sales in the United States. Clearly, these changes have been many years in the making, because at one point, every McDonald's store was in the U.S. In the same way, many international companies have also expanded beyond their domestic bases. For U.S. investors seeking international diversification, this shift can make it difficult to determine which international companies can actually provide effective exposure to foreign markets (Figure 2). Figure 1: Dow Jones Industrial Average member companies Percentage of revenues derived from the U.S. market as of 12/31/11 100% 80% 60% average 55.5% 40% 20% 0% Source: Bloomberg as of 12/31/11 Figure 2: TOP 30 MEMBER COMPANIES IN THE FTSE 100 Percentage of revenues derived from European markets as of 12/31/11 100% 80% 60% 40% 20% 0% Anglo American PLC Standard Chartered PLC average 40.8% BHP Billiton PLC An-Busch InBev NV Source: Bloomberg as of 12/31/11 Intel Exxon McDonald s Coke 3M Hewlett-Packard Caterpillar Dupont Procter & Gamble IBM Pfizer Chevron Merck JNJ GE Kraft Cisco Alcoa United Tech Microsoft Boeing Amex WalMart Disney Rio Tinto PLC Nestle SA Unilever NV Diageo PLC Novo Nordisk A/S Sanofi AstraZeneca PLC LVMH Brit Amer Tobacco PLC HSBC Holdings PLC Roche Holding AG Royal Dutch Shell PLC Bayer AG Banco Santander SA Daimler AG SAP AG BASF SE Siemens AG Telefonica SA Novartis AG GlaxoSmithKline PLC Vodafone Group PLC BP PLC ENI SpA Total SA TESCO PLC All stocks are being shown for illustrative purposes only and should not be considered a recommendation to buy or sell any security shown. JPM Bank of America Home Depot Travelers AT&T Verizon
4 Emerging markets are more global, too The popularity of emerging market (EM) stocks has driven their prices higher. But investors looking to profit from fast-growing EM economies should be mindful of which stocks they own. One good example is the Mexican building materials company Cemex. Years ago, it might have been a way to participate in the growth of the Mexican economy. But today, Cemex is a massive international conglomerate. As of 12/31/11, only 22% of its revenues came from Mexico; the rest came from around the world, led by the U.S. (17%), U.K. (8%) and Germany (8%). This dynamic is particularly strong for commodity companies, which rely on global markets. These companies may not even price their products in their local currency, which further distances them from the economy of their domestic markets. With all of these factors in play, achieving meaningful geographical diversification can be surprisingly challenging. Global vs. local In a world where a company s headquarters does not necessarily guarantee access to that country s economy, effective international diversification can be defined by two kinds of firms: Successful companies that dominate their sector globally Successful local companies that provide concentrated access to an individual country s growth prospects There can certainly be companies in the middle, but understanding a fund manager s approach to this distinction may help determine the proper role of the fund in a durable portfolio. Addressing the specific risks While many investors use index funds to invest in international equities, index strategies may invite unintended risk exposures. In most cases, international indexes don t factor in the local or global nature of companies revenue generation, which might lead to inefficient allocations. By contrast, active managers may be able to capitalize on the intrinsic inefficiencies of world markets. Time zones, currency differences, local/regional regulations and geopolitical risk are all part of the international equity equation. World equity markets express the views of millions and millions of investors at any given moment, and these inefficiencies can often be exaggerated due to global capital flows. When global investors are leveraged, it can create tremendous disturbances for smaller, less liquid markets. By examining these issues more closely, international managers may be able to focus their portfolios more precisely to capitalize on specific trends or developments. Unlike index funds, actively managed funds can also manage risk with a variety of strategies. Funds that employ these techniques may be able to moderate risk to the point where they can be used as risk reducers in a durable portfolio. Some risk management strategies include: Currency hedging Variations in the relative value of the dollar can help or hurt returns, depending on how a fund is managed. It s important to understand a portfolio manager s time horizon. If there isn t any hedging, the fund increases its exposure to currency volatilities, which may take longer to play out. Conversely, funds that hedge their currency exposure may be a lower-risk choice. Volatility targeting Some international funds may use alternative strategies, quantitative techniques or risk management overlays to constrain the volatility of returns within a specified range. Regulatory considerations How a manager approaches financial regulation can also affect investment decisions. American Depositary Receipts (ADRs) require that foreign companies provide financial statements consistent with U.S. Generally Accepted Accounting Principles (GAAP). Companies without an ADR and only listed on one foreign exchange may not provide the same level of transparency that U.S. investors expect. Indirect investing Sometimes fund managers may find a country s growth rates and economic activity desirable, but may not want to invest in local companies due to obstacles such as transparency, shareholder rights or company valuations. In these cases, an effective strategy might be to own a company which sells into the desired market but is listed elsewhere. For example, much of the recent revenue and profit growth of Daimler (the German auto manufacturer) was driven by consumer demand in India and China. 4
5 Avoiding hot money flows In addition, while a goal of international index investing is returns that are close to those of common benchmarks, it also captures those indexes volatility, for better or worse. In many cases, the fastest-growing companies and sectors are added to the indexes while they are running very hot. These types of scenarios tend to end badly, with massive selling once the company or sector is deemed overvalued. Active managers may be more likely to see through the wild valuations and speculation and avoid that particular risk. As a result, they might underperform in the short run by not owning the hottest idea, but may also be less likely to underperform when the run is over. A smarter approach to international equities In an increasingly global marketplace, low interest rates, high volatility and global event risk are making it harder to achieve the consistent returns most investors prefer. Natixis Global Asset Management is addressing this concern with an approach known as Durable Portfolio Construction ȘM a foundation for investing based on smarter strategies for managing risk, managing volatility and enhancing diversification. International investments in a durable portfolio: the implications For investment firms Consider expanding platform offerings to include actively risk-managed and concentrated international equity funds to help meet demand from financial advisors and their clients. For financial professionals Become familiar with Durable Portfolio Construction and the investment solutions available to help create better riskmanaged portfolios for investors. For investors Learn more about how investments other than traditional U.S. stock and bond funds may help improve diversification and potentially lower overall portfolio risk. Risks associated with International Equities: Funds that invest in foreign securities involve risks not associated with domestic securities, such as currency fluctuations, differing political and economic conditions, and different accounting standards. These risks are generally magnified in emerging markets. A portfolio that holds fewer securities than a non-concentrated fund, or focuses its investments in one sector or industry, may involve greater risks and price volatility than more broadly diversified funds. Equity securities may be subject to unpredictable declines in value. 5
6 NATIXIS GLOBAL ASSET MANAGEMENT, S.A. Natixis Global Asset Management ($748.2 billion AUM 1 ) is a subsidiary of Natixis, the corporate, investment management and financial services arm of Groupe BPCE. The firm ranks as one of the 15 largest asset management companies in the world. 2 As a multi-boutique firm with more than 20 affiliates in the U.S., Europe and Asia, it provides a direct connection to a world of specialized professionals with unique insights and diverse approaches to investing. They re influential thinkers who can help create proactive strategies that respond to changing market conditions. Across the globe, the firm s hallmark is a consultative approach that starts with listening and understanding client needs and a process that goes beyond products to create a comprehensive investment solution for institutions, intermediaries and individuals alike. It s called Better thinking. Together. and it helps clients around the globe make the most of complex markets. 1 As of March 31, Cerulli Quantitative Update: Global Markets 2011, based on December 31, 2010 AUM of $713 billion. NGAM Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Global Asset Management, L.P. NGAM Distribution, L.P. is located at 399 Boylston Street, Boston, MA ngam.natixis.com WP
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