International equity funds: On a road to nowhere?

Could the start of 2010 signal the end of international equity funds? Janine Mace finds out.

In the post global financial crisis world, a key issue for Australian investors may well be the need to rethink their international equity allocations.

In the past, most investors simply opted for an international equity fund and let the magic of the index do the hard work of choosing where the money went.

As the majority of international indices are heavily weighted towards developed markets such as the US and Europe, the performance of most international equity funds is reliant on the performance of the economies in advanced nations.

Although this worked well in an era of strong growth in developed economies, questions are increasingly being raised about the suitability of this approach in a low growth era.

As AMP Capital Investors head of investment strategy Dr Shane Oliver pointed out in a recent research note, "The greater importance of the emerging world and the constrained, more fragile outlook for the US and other developed countries have a number of implications for investors".

The most significant of these is whether traditional international equity funds remain the best way to gain exposure to growing economies and companies outside Australia.

"Investors need to move away from the concept of traditional international equity funds and, instead, allocate more to stronger-growth Asian and other emerging markets," Oliver argues.

His reasoning is that traditional international equity funds are benchmarked against indices with an 80 per cent or 90 per cent exposure to slow-growth advanced countries.

"They are lagging way behind the reality that the emerging world is now playing a much larger role in the global economy, and that role is set to become even larger still," Oliver says.

Aberdeen Asset Management senior investment specialist Stuart James agrees investors need to look closely at the composition of the fund they are investing in when they set their money to work offshore.

He points out the MSCI World Index contains a zero exposure to emerging markets, as it is designed to measure the equity market performance of developed markets.

Even the MSCI ACWI (All Country World Index), which is designed to measure the equity market performance of both developed and emerging markets, includes only a 10 per cent exposure to emerging markets.

"Generally, people are very underexposed to emerging markets in their portfolios," James says.

By selecting equities funds that use very broad world indices as their benchmark, James believes investors are betting on the slow recovery occurring in developed

markets, rather than the rapid recovery and current growth being experienced in developing economies.

According to HSBC’s UK-based chief economist, Stephen King, the engine of economic growth is shifting and investors need to consider this when making their investment allocations.

"Emerging nations are going from strength to strength and a global recovery is likely to be emerging markets-led. Drivers of the global economy continue to shift to the East and we are seeing emerging nations becoming increasingly dependent on each other rather than on the economies of developed countries," he says.

HSBC Australia head of global investment Charles Genocchio agrees there are important structural changes occurring in the global economy.

"The developed countries are developed, so why would you put money into them?" he says.

By way of evidence, Genocchio points to the measly 1 per cent annual growth in Japan over the past 20 years. "So why would you invest into it?"

While acknowledging the risks inherent in emerging market investments, Oliver feels investors cannot afford to ignore these changes in growth patterns and what they mean for investing offshore.

"The rise in the relative fortunes of emerging countries versus developed countries is different enough to have significant implications for investors," he says.

Genocchio believes these trends have important long-term implications for planners in developing international allocations for clients.

"Planners need to get the message out to clients that international equities are not a good investment as they are not high income producers, but they are important for growth and that growth will come from emerging markets more than developed markets," he says.

"They need to be saying this is a quite diversified bunch of growth assets around the world and you need to have it if you want growth in your portfolio. If you are investing for growth then emerging markets is the place to be."

James agrees planners and their clients cannot afford to overlook the increasingly important role emerging markets are playing in global growth.

"Twenty per cent of their international equities exposure should be in emerging markets," he says.

Talking the BRIC road

While a simple international equities fund may not necessarily be the best approach to accessing global economic growth in the future, simply opting for a Brazil, Russia, India and China (BRIC) fund may not be a great idea either.

"BRIC has been a nice marketing tool and it has given planners a way to talk to clients about these countries," Genocchio says. "But when it comes to emerging markets, we don’t see BRIC as the best way to invest."

James is another with little faith in the BRIC approach. "BRIC is a clever marketing acronym, but it is very narrow and it’s a bit short-sighted to invest that way."

While the BRIC markets are the heart of the emerging markets story, there are substantial differences between the four countries and their individual growth prospects. For example, China has few companies Aberdeen currently sees as good value investments, "even though it has a great macro story", James says.

The other countries in the grouping also need evaluating individually.

"India has a great consumer story and its long-term future is exciting," he says.

"When it comes to Brazil, its oil story is great, but in Russia the corporate governance is relatively poor compared to other emerging market countries."

Genocchio agrees investors need to choose carefully between the various emerging market countries.

"Russia has serious structural issues and it is difficult to see growth there, although we like the energy side," he says.

For James, there are several good investment opportunities outside the BRIC grouping to which investors should seek exposure.

"You can buy companies in countries like Indonesia and Mexico that are not in the BRIC group and they are very attractive," he says.

Genocchio is also a fan of Indonesia. "Indonesia is an amazing country. Maybe it should be ‘BIIC’ rather than BRIC."

He believes the differences between the BRIC countries means investors should consider looking at investment funds benchmarked to other indices.

"We prefer Asia or the total emerging market as a benchmark rather than using BRIC," Genocchio says.

Index providers are increasingly recognising these changing trends and are developing new index options that will allow investors to be more discerning with their international equity allocations.

In December, Standard & Poor’s (S&P) launched the S&P/IFCI Carbon Efficient Index, which measures the performance of investable emerging market companies whose weighting in the index is based in part on their level of carbon emissions. The index covers 21 emerging markets and more than 800 companies.

According to S&P, the launch of the index is designed to allow investors to increase their exposure to emerging markets while also selecting carbon efficient companies.