Industry insiders on why advisors must look at the broader opportunities created by new market dynamics
The world is getting smaller and, let’s be honest, money moves a lot quicker than people right now. For those looking for diversification in their portfolio, investors must look at the broader opportunities the new market dynamics have presented to them.
That’s the view of Sunder Ramkumar, senior manager, client analytics, and Michelle Black, solutions portfolio manager, at Capital Group, who believe rapid advancements in technology and growth in emerging markets are transforming the structure of the economic world and having a significant impact on the universe of investment opportunities.
Traditional diversification is not what it used to be. There is an increasingly greater correlation between U.S. and non-U.S. equities. International equities can improve the breadth of investment choice for skillful managers, while investors should reconsider rigid geographic allocations in favour of flexible global mandates that can help generate potentially better outcomes.
“We’ve found that digging into where a company generates its revenue is a much more practical and transparent yardstick for its global exposure than just the domicile or country of listing,” Black said.
“Take the Standard & Poor’s 500 Composite Index: all of its member companies are headquartered in the U.S., but about 38% of the sales those companies generate come from outside America. A similar picture takes shape in Europe, where the 10 largest corporations in the MSCI Europe Index derive approximately 69% of revenues from outside Europe — partly due to slower growth in their region and better opportunities abroad.
“This change in the landscape of investment opportunities forces a re-evaluation of whether investment portfolios should be built along strict regional lines or a corporation’s place of domicile.”
In addition, correlations have become less differentiated between U.S. and non-U.S. equities. International investing has traditionally been seen as a source of diversification and risk mitigation for U.S. investors.
The monthly correlation between the S&P 500 Index for U.S. equities and the MSCI EAFE Index for non-U.S. equities was only 0.50 from 1970–1998 but global equity markets have become increasingly interconnected, and correlations have steadily crept up since the mid-1990s. In fact, monthly return correlations have almost doubled to 0.86 over the past 20 years.
Ramkumar said: “If correlations between U.S. and non-U.S. equities remain more tightly linked in a more globalized world, should investors forget international investments altogether? No, but they should re-think what global investing means for their portfolios. As diversification and risk benefits have become less pronounced, international equities can be seen as a means for stock investors to pursue a broader opportunity set by homing in on individual companies.
“History shows companies can transcend indices. We believe global flexibility is a critical consideration in designing a ‘future-proof’ portfolio amid the changing dynamics of business and trade. As borders blur, the ability to invest in companies anywhere around the world is taking on greater importance, especially for investors seeking a wider array of options to capture the value of global opportunities.”
With this in mind, both Ramkumar and Black believe that, in the portfolio construction process, the ability to break free of regional borders, pick investment managers with a global mindset and the capacity to implement a flexible approach in terms of asset allocation can be beneficial.
For example, shares of non-U.S. companies with significant exposure to the U.S. economy (40% or more of annual revenue) have done notably well since 2008, as opposed to those firms with less U.S. exposure, based on cumulative relative returns of components listed in the MSCI All Country World Index (represents 85% of the global investable equity opportunity set).
At the industry sector level, there are examples where having the flexibility to cut across multiple geographies can present a wider menu of investment options.
Take the semiconductor business, where makers of computer chips and communications circuits supply a diverse range of end markets such as smartphones, personal computers, automobiles and cloud-computer server systems.
Black explained that the global opportunity consists of 42 companies with a market value of more than US$1.3 trillion, based on the components listed in the semiconductor subsector of the MSCI ACWI as of September 30, 2016.
“If restricted by domicile, a U.S. bias would limit choice to 17 companies and preclude an opportunity to own shares of Taiwan Semiconductor Manufacturing (TSMC), the index’s largest component by market value and a highly specialized producer of madeto-order microchips for Apple and leading U.S. semiconductor companies.
“Having exposure to U.S. business has been beneficial for TSMC; the Taiwan-listed company generated more than 64% of its 2016 revenue from the United States. As can be seen in the chart below, top-quartile funds whose managers have the flexibility to invest across the world have generated better results than the index.
“For the 20-year period ended December 31, 2018, the top quartile of global funds tracked by Morningstar exceeded the return of the S&P 500 by 390 basis points and the MSCI All Country World Index (ACWI) by 500 basis points. Not only that, they also matched - and slightly outpaced - the returns of the top quartile U.S.-equity funds, despite significant headwinds to international equities in aggregate, demonstrating that above average funds may be able to capture the value of global opportunities.”
