January 2015 CONTRIBUTOR Michael Orzano, CFA Director, Global Equity Indices michael.orzano@spdji.com Looking Down Under: An Approach to Global Equity Indexing in Australia The benefits of incorporating international equities and other asset classes into the portfolio construction process have been widely cited in investment research and, over time, have been commonly adopted as a basic tenet of asset allocation and portfolio management. There are two key advantages of taking a global approach to equity investing. First, a global approach expands the investment opportunity set, allowing investments in sectors and industries that may be poorly represented or entirely absent from a home country s equity market. Second, a global approach improves the diversification of assets and may reduce overall portfolio volatility or improve risk-adjusted total returns, without necessitating an increase in allocations to lower-risk assets. Despite overwhelming evidence supporting the benefits of international diversification, many investors throughout the world continue to exhibit biases to local equity markets. Since its equity market is relatively small and heavily concentrated in a few key sectors, the potential drawbacks of limiting exposure to domestic equities can be particularly acute in Australia. AUSTRALIA IN THE CONTEXT OF THE GLOBAL EQUITY MARKET Although Australia is home to a large and dynamic stock market, it represents just a fraction of the available universe of investable global equities. In fact, Australia represents less than 3% of the S&P Global BMI (Broad Market Index), which is a comprehensive benchmark that includes large-, mid- and small-cap stocks across 48 developed and emerging markets. Exhibit 1: S&P Global BMI Regional Weights Australia 2.4% Asia Pacific Ex- Australia 12.0% Canada 3.3% US 50.3% Emerging Markets 9.9% Europe 21.9% Source: S&P Dow Jones Indices LLC. Data as of Jan. 30, 2015. Charts and tables are provided for illustrative purposes.
AVOIDING CONCENTRATION RISK The Australian stock market is heavily concentrated by sector and industry, and it has a high concentration in relatively few large companies. As a result, single-country investments in Australia carry high levels of sectorand stock-specific risk. As illustrated in Exhibit 2, nearly two-thirds of the Australian market (as proxied by the S&P/ASX 200) is represented by just two sectors, financials and materials, and within these sectors there is a high concentration in banks and mining. On the other hand, the S&P Developed Ex-Australia LargeMidCap includes large- and mid-capitalization stocks from all developed markets outside of Australia; thus, it has much more sector and industry diversification. In addition, large and innovative industries such as information technology, pharmaceuticals, and aerospace and defense are almost entirely absent from the Australian market. Exhibit 2: Comparative Sector Weights Sector S&P/ASX 200 (%) S&P Developed Ex-Australia LargeMidCap (%) Financials 47.5 19.2 Materials 14.6 4.8 Consumer Staples 7.4 10.2 Industrials 7.2 11.3 Energy 6.2 3.4 Telecommunication Services 5.8 13.2 Healthcare 4.7 7.7 Consumer Discretionary 4.0 12.7 Utilities 1.9 3.5 Information Technology 0.7 14.0 Source: S&P Dow Jones Indices LLC. Data as of Jan. 30, 2015. Charts and tables are provided for illustrative purposes. Exhibit 3: Stock Concentration in the Australian Market (Combined Weights of Top 5, 10 and 25 Stocks in the S&P/ASX 200) 80% 72% 60% 54% 40% 38% 20% 0% Top 5 Top 10 Top 25 Source: S&P Dow Jones Indices LLC. Data as of Jan. 30, 2015. Charts and tables are provided for illustrative purposes. REDUCING RISK THROUGH DIVERSIFICATION The S&P/ASX 200, with its strong concentration in two sectors, is not well correlated to international equities. Over the years, as illustrated by the data set forth in Exhibit 4, history has shown that combining Australian stocks with international stocks may result in lower total risk than the individual components. Exhibit 4 shows performance and volatility for a hypothetical portfolio constructed with equal 50% weights to the S&P/ASX 200 2
(Australian stocks) and the S&P Developed Ex-Australia LargeMidCap Indices (International stocks) over the past 5 years. The strong relative performance of international equity markets drove outperformance of the hypothetical global equity portfolio relative to Australian stocks. However, the hypothetical global portfolio also had lower volatility then either the S&P/ASX 200 or S&P Developed ex-australia LargeMidCap due to the low correlation between the two indices. Exhibit 4: Performance Characteristics of Australian and International Equities Asset Category Total Return (%) Risk (%) Return/Risk Australian Stocks 8.8 11.8 0.75 International Stocks 14.4 9.6 1.50 Hypothetical Global Equity Portfolio 11.6 8.2 1.41 Source: S&P Dow Jones Indices LLC. Data from January 2010 to January 2015. Australian Stocks and International Stocks are represented by the S&P/ASX 200 and the S&P Developed Ex-Australia LargeMidCap, respectively. All figures are annualized and based on calculations using total return index levels in AUD. Total Risk is calculated as the annualized standard deviation using monthly total returns. The Hypothetical Global Equity Portfolio is constructed with a 50% weight to each index. Past performance is no guarantee of future results. Charts and tables are provided for illustrative puroses. Including emerging market equities and listed real estate securities could also provide additional diversification. Exhibit 5 depicts a hypothetical global equity portfolio constructed with a 40% allocation each to Australian and international equities (represented by the S&P/ASX 200 and the S&P Developed Ex-Australia LargeMidCap, respectively, as before) and a 10% allocation each to emerging market equities (S&P Emerging LargeMidCap) and global real estate securities (Dow Jones Global Select Real Estate Securities Index). Exhibit 5: Performance Characteristics of Major Equity Asset Classes Asset Category Total Return (%) Risk (%) Return/Risk Australian Stocks 8.8 11.8 0.75 International Stocks 14.4 9.6 1.50 Emerging Market Stocks 6.2 10.0 0.62 Global Real Estate Stocks 19.3 9.8 1.96 Hypothetical Global Equity Portoflio 11.8 7.9 1.50 Source: S&P Dow Jones Indices LLC. Data from January 2010 to January 2015. Australian Stocks, International Stocks, Emerging Markets Stocks, and Global Real Estate Stocks are represented by the S&P/ASX 200, S&P Developed Ex-Australia LargeMidCap, S&P Emerging LargeMidCap and Dow Jones Global Select Real Estate Securities Index SM (RESI), respectively. All figures are annualized and based on calculations using total return index levels in AUD. Total Risk is calculated as the annualized standard deviation using monthly total returns. The Hypothetical Global Equity Portfolio is constructed with a 40% weight each to Australian and International Stocks and 10% weight each to Emerging Markets Stocks and Global Real Estate Stocks. Past performance is no gurantee of future results. Charts and tables are provided for illustrative purposes. This analysis again demonstrates the advantages of portfolio diversification. The inclusion of emerging markets and global real estate securities further reduced risk and slightly improves both total return and risk-adjusted returns compared to the portfolio comprised solely of Australian and International Stocks. A CLOSER LOOK AT CORRELATIONS Exhibit 6 displays correlations for indices that represent a variety of core asset classes. Australian equities have had a correlation of just 0.17 to international equities over the past five years. However, much of the diversification benefit appears to be driven by foreign currency exposure since the S&P Developed Ex-Australia LargeMidCap AUD Hedged has posted a much higher correlation of 0.71. Also noteworthy is that Australian equities have had a higher correlation to emerging markets than to developed international equities. This is likely driven by the Australian market s interconnection with emerging market economies through its high exposure to the mining sector. 3
Exhibit 6: Five-Year Correlation Matrix of Major Equity Asset Classes Index S&P/ASX 200 S&P Developed Ex- Australia LargeMidCap S&P Developed Ex- Australia LargeMidCap AUD Hedged S&P Emerging LargeMidCap Dow Jones Global Select RESI S&P/ASX 200 1.00 - - - - S&P Developed Ex-Australia LargeMidCap S&P Developed Ex-Australia LargeMidCap AUD Hedged 0.17 1.00 - - - 0.71 0.46 1.00 - - S&P Emerging LargeMidCap 0.50 0.53 0.56 1.00 - Dow Jones Global Select RESI 0.37 0.51 0.28 0.42 1.00 Source: S&P Dow Jones Indices LLC. Data as of Jan. 30, 2015. Calculations are based on monthly total returns in AUD. RESI: Real Estate Securities Index. Past performance is no guarantee of future results. Charts and tables are provided for illustrative purposes and may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance. THE IMPORTANCE OF CURRENCY RISK Investments in international equities involve exposure to foreign currency risk, and currency movements can have a substantial impact on total returns and volatility. Economic theory tells us that currency exposure generally should not affect international equity returns over the long term. However, over the short term, currencies may fluctuate dramatically. Exhibit 7: A Comparison of Hedged and Unhedged Annualized Returns of the S&P Developed Ex-Australia LargeMidCap Year Unhedged (%) Hedged (%) Difference (%) 2014 15.4 12.9 2.5 2013 47.8 32.4 15.4 2012 15.1 19.8-4.7 2011-5.1-1.8-3.3 2010-1.2 14.0-15.2 2009 1.4 28.8-27.3 Period Unhedged (%) Hedged (%) Difference (%) 1-Year 20.7 16.1 4.6 3-Year 26.0 19.4 6.6 5-Year 14.4 15.6-1.2 10-Year 6.7 9.1-2.5 Source: S&P Dow Jones Indices LLC. Data as of Jan. 30, 2015. Calculations are based on total returns in AUD. Periods over one year are annualized. Past performance is no guarantee of future results. Charts and tables are provided for illustrative purposes. Exhibit 7 illustrates the impact of movements in the Australian dollar on international equity returns over the past several years. In 2013 and 2014, a weakening Australian dollar resulted in enhanced returns of international equities in Australian dollar terms. However, consistent strengthening of the Australian dollar between 2009 and 2012 resulted in benefits from hedging. Currency hedged indices and associated investment products exist in the marketplace to assist in the management of currency risk. CONCLUSION As illustrated by the data set forth in this paper, there are potential benefits from taking a global approach to equity investing. Diversifying into international equities expands the investment opportunity pool, provides the ability to access fast-growing and dynamic industries that may be poorly represented in the local market and can help in trying to reduce total portfolio risk by combining assets with low correlations. 4
APPENDIX: INDEX DESCRIPTIONS S&P/ASX 200 The S&P/ASX 200 is widely recognized as the leading investable benchmark in Australia. The index covers approximately 80% of the Australian equity market and is weighted by float-adjusted market capitalization. S&P Developed Ex-Australia LargeMidCap The S&P Developed Ex-Australia LargeMidCap is a float-adjusted, market-capitalization-weighted index that includes large- and mid-cap companies across 25 developed equity markets. The index is a member of the S&P Global BMI (Broad Market Index) series and includes approximately 85% of the available market capitalization from each country. S&P Developed Ex-Australia LargeMidCap AUD Hedged The S&P Developed Ex-Australia LargeMidCap AUD Hedged is a float-adjusted, market-capitalization-weighted index comprising large- and mid-cap companies across 25 developed markets. Foreign currency exposures are hedged to reduce the impact of foreign currency fluctuations between the currency in which each constituent is denominated and the Australian dollar. This index is part of the S&P Global BMI series. S&P Emerging LargeMidCap Combining the S&P Emerging LargeCap and S&P Emerging MidCap indices, the S&P Emerging LargeMidCap comprises the stocks representing the top 85% of float-adjusted market cap in each emerging country. It is a subset of the S&P Global BMI series. Dow Jones Global Select Real Estate Securities Index (RESI) The Dow Jones Global Select RESI is designed to measure the performance of publicly traded real estate securities. Eligible for inclusion are real estate investment trusts (REITs) and real estate operating companies (REOCs) based in 46 developed and emerging markets. Constituents must meet minimum size and liquidity criteria. The index is designed to serve as a proxy for direct real estate investments, in part by excluding companies whose performance may be driven by factors other than the value of real estate. 5
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PERFORMANCE DISCLOSURES The Dow Jones Global Select RESI (AUD) was launched July 22, 2013 at market close. All information presented prior to the Launch Date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spdji.com. S&P Dow Jones Indices defines various dates to assist our clients in providing transparency on their products. The First Value Date is the first day for which there is a calculated value (either live or back-tested) for a given index. The Base Date is the date at which the Index is set at a fixed value for calculation purposes. The Launch Date designates the date upon which the values of an index are first considered live; index values provided for any date or time period prior to the index s Launch Date are considered back-tested. S&P Dow Jones Indices defines the Launch Date as the date by which the values of an index are known to have been released to the public, for example via the company s public Web site or its datafeed to external parties. For Dow Jones-branded indices introduced prior to May 31, 2013, the Launch Date (which prior to May 31, 2013, was termed Date of Introduction ) is set at a date upon which no further changes were permitted to be made to the index methodology, but that may have been prior to the Index s public release date. Past performance of the Index is not an indication of future results. Prospective application of the methodology used to construct the Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the Index. Please refer to the methodology paper for the Index, available at www.spdji.com for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. Another limitation of using back-tested information is that the back-tested calculation is generally prepared with the benefit of hindsight. Back-tested information reflects the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. Additionally, it is not possible to invest directly in an Index. The Index returns shown do not represent the results of actual trading of investable assets/securities. S&P Dow Jones Indices maintains the Index and calculates the Index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the Index or investment funds that are intended to track the performance of the Index. The imposition of these fees and charges would cause actual and back-tested performance of the securities/fund to be lower than the Index performance shown. For example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US$ 10,000) and an actual asset-based fee of 1.5% was imposed at the end of the period on the investment plus accrued interest (or US$ 1,650), the net return would be 8.35% (or US$ 8,350) for the year. Over a three-year period, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US$ 5,375, and a cumulative net return of 27.2% (or US$ 27,200). 7
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