Global Investing (updated 27 Feb 99)

'Don't put all your eggs in one basket', the principle of portfolio diversification, is widely accepted by investors. It is normally thought of in terms of the number of assets, industries or companies across which an investor is spread: a well-diversified portfolio contains equities (as well as bonds, cash, etc.) in industries whose returns do not move together. And the lower the correlation between the returns on the various equities or other assets, the less wildly the value of your whole portfolio should swing.

Less frequently is diversification considered in relation to owning equities and other assets from different countries. But with many national markets often highly uncorrelated, this form of diversification would seem to offer the strongest potential for reducing risk, while at the same time promising enhanced returns. Particularly for investors in one of the highly valued markets of the developed world, buying foreign equities uncorrelated with your domestic market should, in principle, make your overall equity portfolio less risky and more valuable.

So global investing is in the first instance about asset allocation between equities, bonds, cash and other instruments; and second, about investing in global markets. Asset allocators benefit by diversifying across asset classes; international investors benefit by diversifying their portfolio across assets in a range of different countries. The key factor for the latter is the degree of integration of the real economies of the countries concerned. It is important to understand co-movements among different markets: the more markets move together, the fewer the benefits of international diversification.

Global data for 1998 reveals significant performance differentials between regions. The MSCI World Index rose 19.7% but only two regions - Europe at 26.5% and North America at 27.1% - exceeded that. Across the emerging markets, performance ranged from a spectacular 137.5% gain in South Korea to an 83.2% decline for Russia (see EMERGING MARKETS). Though somewhat narrower, differences in the developed world are just as striking: Finland gained 119.1% while Norway declined 31.2%. This large regional performance differential underscores the importance of a global portfolio strategy. An asset allocation strategy that on average correctly anticipated these differences would have added significant value.

Global investment provides a security hedge and a currency hedge. Frequently, investors do not separate the two (see FOREIGN EXCHANGE). Nearly all academic studies suggest that the question of currency hedging should be dealt with explicitly and should not be treated as incorporated automatically within the overall global allocation. And it is important to recognize that currency hedging may be costly and can increase risk. The Asian meltdown in 1998, for example, led to the double whammy of currency devaluation and stock market collapse.

Global investing guru: Gary Brinson

Gary Brinson is a staunch advocate of asset allocation techniques and a pioneer of global investing. In 1974, the firm now known as Brinson Partners (then a unit of First Chicago) was one of the first to invest overseas. Brinson led a management buyout of the unit in 1989 and the firm was later acquired by Swiss Bank Corporation. The latter has since merged with Union Bank of Switzerland and as a result, Brinson directs over $300 billion in institutional assets, making it one of the world's largest money managers. Brinson is also co-author with Yale finance professor Roger Ibbotson of a book about asset classes, investment theory and international investing.

The Swiss banks were interested in Brinson Partners for their money management business but perhaps even more for their ability to bring North American investment techniques to Europe and elsewhere in their network. Features that are taken for granted in the United States like performance measurement, incentive compensation, quantitative tools and hedging are less familiar in Europe (see PERFORMANCE MEASUREMENT, QUANTITATIVE INVESTING and RISK MANAGEMENT). At first, the relationships were rather loose with interns coming to the Chicago headquarters for training and management coordination with the Swiss management largely by encrypted videoconferencing. More recently, the risk management and tighter controls at headquarters have dictated closer ties.

Brinson has promoted the professionalism of investment management by taking an active part in its industry association, the Association of Investment Management & Research (AIMR) and its Research Foundation. He is an advocate of small, steady incremental gains in improvement of standards. Similarly, he is an advocate for small changes in asset allocation. Consistent with the Swiss style of investing, major swings are generally unlikely to take place.

Brinson argues strongly that investment decisions should focus first and foremost on markets or asset classes since that explains roughly 90% of returns. The key is to consider overall portfolio risk rather than the risk of individual assets: a sound asset allocation combines diverse asset classes in ways that increase returns without an equal increase in risk - or reduce risk without sacrificing returns.

The world is getting smaller, so your portfolio should be getting broader, Brinson contends: 'For people to say just because I'm a resident of the United States that I'm going to restrict my investments to the United States is terribly myopic and numerous studies have shown that it really curtails investment opportunities. The more one thinks about global investment opportunities, the greater the chances of success.' His global asset allocation strategy rests on four basic principles:

· Think global.

· The value of asset classes should not rise and fall together.

· Focus on the long term.

· Monitor and adjust allocations to accommodate changed investment climates.

Brinson believes that in a relatively short time, it will seem as odd to most investors to discuss a Europe fund's country allocations as it does now to discuss a US fund's relative exposure to each of the fifty states. In his mind, country concerns will be minimal in comparison with company concerns.

Counterpoint

If global investing is superior to investing in only one market, why do so many investors hold disproportionate amounts of their portfolios in equities of their own domestic markets? Even sophisticated institutional investors, such as pension funds and insurance companies, tend to concentrate well over three-quarters of their equity funds in domestically quoted shares, a phenomenon known as 'home bias'. Evidence of wide discrepancies between national market performances over certain periods of time suggests that these investors would maximize their returns and minimize their risks more effectively by diversifying more fully across stocks in different countries.

Various explanations for home bias have been advanced. These include IMF officials' arguments that it is, in large part, due to the substantial risks of adverse exchange rate changes, which cannot be guarded against with standard hedging techniques. Currency risks may be compounded by the different supervisory environments in particular markets, by fears that capital controls may be instituted, by taxes on international trading or simply by a wish to avoid the time and expense of maintaining and researching a more widely spread international portfolio.

Such reasoning is supported by arguments that the benefits of international diversification arise merely from the fact that different stock markets have their shares concentrated in different industries. For example, the UK privatization program of the 1980s means that utilities are a more important part of the London market than elsewhere (see INITIAL PUBLIC OFFERINGS). Similarly, investment in the Swiss market implies a disproportionate bet on banking stocks, and investment in the Swedish market a commitment to basic industries. The implication is that global investing offers nothing more than exposure to additional industries.

Yet home bias on the part of institutional investors seems to be more a result of government restrictions on the amount of foreign assets pension funds and insurance companies in any given country are allowed to hold. It also may arise from the way in which fund managers' performance is assessed through reference to a local market index: even if passive indexing is not their dominant strategy, there is inevitably a strong incentive to own a good slice of the index's components (see INDEXING). And industry analysts are often more prevalent than country analysts in fund managers' offices, suggesting a disposition to choose industrial over international diversification.

There is evidence that the covariances of global markets may be sliding closer, though Japan may be a special case. For the other members of the G-7, coordinated banking policies and facilitated information flows should tend to drive markets into a more steady alignment. On the surface, such an increase in stability could be seen as beneficial for business but would be a lessened benefit for portfolio investors attempting to diversify risk.

For example, closer links between European economies following the introduction of the euro will increase the incentive for US investors to diversify into European markets. At the same time, this may also strengthen the relationship between different European stock markets, reducing the incentive for diversification within Europe.

Where next?

Recent research indicates that Americans are more likely to invest in their local regional Bell operating company than in any other. Considering that everyone's local operator cannot be a better investment choice than any of the other six, this finding suggests the importance of investors' psychological need to feel comfortable with where they put their money. Perhaps it relates to the 'endowment effect', a phenomenon noted by behavioral finance, where people set a higher value on something they already own than they would be prepared to pay to acquire it (see INVESTOR PSYCHOLOGY).

But if people still do have a predilection for investing in familiar stocks, they are likely to leave largely unexploited international investment opportunities and hold sub-optimally diversified portfolios. It is tempting to conjecture that such a psychological attitude might be even more pronounced in the highly diverse cultural contexts of European countries. Such an attitude could explain the lack of cross-country portfolio investments within Europe, and suggest that the internationalization of European individual portfolios will be a slow process even in the wake of the euro.

On the other hand , the potential development of a European identity and the increasing tendency to 'think European' rather than 'French' or 'German' - a tendency that is likely to be enhanced by the advent of a shared currency - could make European investors less reluctant to hold equity stakes in companies residing in a European state different from their own. Perhaps European home bias will fade.

Of course, none of the reasons for home bias apply to the individual global investor with the funds, access to broking services and time to conduct research on the opportunities in the international equity market. It seems likely that home bias and low market correlation will diminish over time as the interconnections of the global economy become closer and the confidence of investors in overseas markets grows. But, in the meantime, by leaving some lower risk and higher return possibilities relatively unexplored, they might help you to formulate an international investment strategy that can beat the market consistently.

There is also now a vast amount of information on global investment opportunities available on the internet. Any point on the globe is as accessible as next door. It is cheap and often free. It shifts control of time, depth of information and source to empower the user. And it is open: anyone can come in taking its knowledge and offering skills. Financial centers are described on a satellite connection, not geographic coordinates or proximity to other financial talent centers. Work takes a different form in time and space with email, videoconferencing and the internet, all of which is available at a price for the single user at his or her own site. Location becomes irrelevant.

A visit to South Africa from the United States, for example, requires probably a week of preparation, a week there, and a week of decompression on the other side - a total of three weeks, assuming we are efficient. Compare that with a day on the internet. How much information could one get on South Africa in the course of a few hours on the web? The information might be different, but it is going to be a large volume in a short period of time. You would understand the culture and the issues, and you could gain a lot of information that is hard to find out otherwise.

According to that well-known fan of investment management, Bill Gates: 'Anyone who is not intimately involved with the Internet and the web does so at extreme peril.' This statement applies to particular force to investment analysts and private investors. For those of us who are dedicated to moving our craft forward, being ahead of others and using the best tools available, the internet is our mandate.

Read on

In print

Stephen Eckett, Investing Online: Dealing in Global Markets on the Internet
Roger Ibbotson and Gary Brinson, Global Investing: The Professional's Guide to the World Capital Markets

Online

www.global-investor.com - Stephen Eckett's website with lots of useful links for the global investor
www.idea-globalmarket.com - subscription website of the Global Market Network