Incorporating international equities into a portfolio

The world is bigger than just holding Australian equities in a portfolio, as many investors are now discovering.

Macquarie Wealth Management associate director Doug Webber said clients seem to be more interested in international shares than the local market.

“They seem to accept Australian shares, such as CBA, Woollies and BHP, as essential parts of their portfolios, but boring,” he said. “Clients want to talk more about international exposure and countries in their portfolios.”

There are a number of very good reasons for including international equities in a portfolio.

The obvious reason is it reduces the client’s dependence on the local market, which, depending on the economist you listen to, is overheated.

A global approach to investing also enables the client to gain exposure to industries that are not in Australia, as well as international blue chip giants. These include companies like IBM, Toyota, Shell and Boeing.

It also reduces risk if there is a downturn in a particular country or continent, as it is rare in today’s world that the entire global economy heads into recession in unison.

Even if the US went into recession, it is now generally accepted that China would still be reporting strong growth.

However, for Australian investors, it is still hard to access direct international shares because of currency fluctuations and a lack of knowledge about what markets are doing in a particular country.

The alternative is to use managed funds, and for good portfolio construction it is wise to blend a couple of managers to gain access to differing investment styles.

A typical mix might include an indexed manager to gain good exposure to the MSCI Index and a growth manager to deliver some benchmark outperformance.

By blending managers, the investor can get a good geographical spread in both established and emerging markets.

Using a couple of managers also provides access to different global stocks, which can deliver outperformance.

For example, Invesco has almost 50 per cent exposure to the US market while Aberdeen has just 20 per cent.

In performance terms, Vanguard, which is an index fund, will deliver almost exactly what the MSCI is achieving while Equity Trustees, which is an active market investor, has outperformed the index, but with higher risk.

The fees for clients are also reflected in the fund manager’s investment style.

A neutral manager that reflects lower risk has a lower management expense ratio (MER), while at the opposite end of the scale an active manager looking to deliver absolute return has the higher fees to reflect the risk the manager is taking, but is hopefully delivering outperformance.

For many advisers, building a portfolio of international fund managers is easier, as a number of research houses produce approved lists of managers and model portfolios.

Zenith Investment Partners is currently undertaking a sector review of international fund managers that will produce a recommended list for portfolio construction.

Senior investment analyst Ben Davis said it was a multi-document review to create portfolios that can be used on platforms.

“We aim to construct portfolios that outperform MSCI World ex-Australia Index over the medium to long term,” he said.

“The portfolios are tailored specifically for the investment platforms used by our clients, such as BT, Macquarie Wrap and FirstChoice.”

Zenith’s initial response is a quantitative filter that will show who will outperform.

After this there is a face-to-face interview with those managers that will look at track record and risk management.

“We have a strong focus on risk management,” Davis said.

“We try to ensure the portfolio is well diversified by style and geographical and sector allocation.”

The researcher achieves this by using models to monitor style drift and generate quantitative correlation analysis to ensure the funds within the portfolio continue to blend well.

“We monitor asset allocation and cash holdings to ensure there are no major exposures to regions and sectors and to ensure that the funds are fully invested,” he said.

The aim is to produce a best-of-breed list of managers with complementary styles.

“We use our highest conviction funds that we have identified in our sector review process,” Davis said.

“Any fund selected in the portfolio must reside on our recommended list, which means they have a rating of either ‘recommended’ or ‘highly recommended’.”

Zenith has a preference for global funds that are trying to outperform, which Davis said meant they were building portfolios that had style diversity among the underlying assets.

“So we are looking for a geographical and stock spread in the portfolios,” he said.

“Our portfolios depend on the underlying mix of absolute return and market benchmark.”

Zenith uses a core and satellite approach to portfolios where it blends a style neutral manager as the core of the portfolio and then adds an absolute return fund as the satellite exposure.

The researcher’s current preferred neutral style managers are AQR, which is offered through BT, and Acadian through ColonialFirstState.

“We are attracted to high-quality quant managers in this component of the portfolio based on the consistent excess return profiles they have produced in most market conditions,” Davis said.

“Quant managers are also well positioned to effectively cover the broad universe of this sector.”

The core funds are then blended with absolute managers such as K2, PM Capital, Platinum, and Walter Scott.

“These absolute return strategies reduce the volatility of the portfolio by providing better downside protection than traditional long-only approaches, but primarily add to the ‘alpha generating’ ability of the overall portfolio,” Davis said.

This core and satellite approach is being taken up by a number of advisers for the international component of the client’s portfolio, Vanguard Investments principal, retail, Robin Bowerman said.

“Most advisers were blending managed funds to deliver a return that met the client’s portfolio strategies,” he said.

“We are finding people want to use an indexed fund as the core investment to cover between 30 to 50 per cent of the index.

“This will give the client an investment spread that is in line with the MSCI Index and a return that replicates the index.”

But an indexed fund was not the only solution, with advisers blending an active fund to deliver extra performance.

“Using an index international fund makes a lot of sense as the client gains exposure to the 1,500 stocks in the index but at a lower cost than the active managers,” Bowerman said.

“When clients buy direct shares they buy names they recognise, such as BHP, Telstra or Commonwealth Bank.

“With international shares, investors again want to invest in names they recognise, such as General Electric, Toyota or IBM.

“Because an index fund invests in the major stocks around the world, investors feel comfortable with the shares in the fund as they know the names.”

Another part of blending portfolios is to avoid using managers investing in the same geographical spreads.

Because index funds invest in the geographical weighting in the MSCI regions, advisers need to look at this when blending funds.

“The MSCI Index will have a weighting of about 50 per cent to the US, so advisers need to be aware of this when blending active funds with index funds so they don’t create over-exposure to one region such as the US,” Bowerman said.

But there is a danger of slanting a portfolio towards the latest geographical region that is in favour, warned Macquarie’s Webber.

“Another danger area is following the herd into the so called ‘hot’ countries,” he said.

“When you start to talk about international investing, clients always seem to know about the latest ‘hot’ country and want to invest there.”

Webber said the base view in portfolio construction is to go for the global approach rather than country specific.

“We might have a tilt towards a particular area, but it is not the core investment in the portfolio,” he said.

But this has to be performed with an understanding of the manager’s style.

“The key to blending funds is to understand the manager’s style and make the decisions based on the managers complementing each other,” Webber said.

At Macquarie, advisers work off an approved list of managers and they can be blended from those on the list.

Alternatively, they can use the model portfolios constructed by Mercer, but Webber said the range of choice was more limited.

“Our advisers use both options depending on what the client wants,” he said.

“However, we do let advisers use any fund, as we believe the researchers do the best job at picking the most suitable funds for our approved list.”

Perhaps the final decision in building a portfolio is whether to hedge or unhedge the currency component of the investment process.

Many fund managers offer both hedged and unhedged products, which do produce different returns.

Webber said then the decision on whether to hedge or unhedge the fund being used “boils down to people’s view on what the dollar is doing”, with currency a big part of the decision process.

“The question is whether to hedge or not, and that depends on how the Australian dollar is faring,” he said.