I want to break free

Everyone agrees that there are enormous opportunities for investors when looking globally.

Not only are global valuations more attractive than investing here at home, but also offer the potential for greater diversification compared with the highly concentrated Australian market, which is dominated by financials and materials (see table, page 24 Money Management June 21).

There is a plethora of global equity products for investors: index funds, enhanced index funds, quant funds, fundamental bottom-up stock picking funds, value funds, growth funds and the list goes on.

However, there is little that is radically different. The reason for this is the dominant role benchmarks have come to play in today’s world.

Future performance in global equities for investors could be enhanced if only we could resist the temptation to allow benchmarks to constrain the way we invest.

Benchmarks fulfil an important role in monitoring manager performance, but what began as a useful tool for monitoring market sentiment and behaviour has now come to be a key driver of market behaviour itself because nearly all investment managers use a benchmark as the starting point for building their portfolios.

This is why I believe that few are doing anything radically different in the way they invest.

I’d argue that investors are poorly served by this approach for the following reasons.

1. Being big doesn’t necessarily mean better returns

You’ll find the largest stock weights in global equity benchmarks and for most global equity managers are to companies that are big.

However, being big doesn’t necessarily equate to the best investment return.

A study published in the Financial Analysts Journal Mar/Apr 2005 by Arnott showed that the largest stocks in the US underperformed the market average by significant amounts over the period 1926 to 2004 (see graph 1, page 24 Money Management June 21).

Wouldn’t you rather a portfolio of stocks that had strong prospects for investment returns than a portfolio of stocks chosen simply because they are big?

2. Constrained to hold overpriced assets

Managers often use benchmark-relative risk controls that force managers to hold overpriced assets.

A good example would be the tech bubble of the late 1990s and early 2000s, which saw the tech sector become 36 per cent of the MSCI World index at its peak (see graph 2, page 24 Money Management June 21).

A manager who is unconstrained by a benchmark is free to roam and has the opportunity to rotate out of such overpriced sectors or countries.

3. Restricted universe of investment opportunities

By the way they are defined, benchmarks often omit many attractive small, mid cap and emerging market opportunities from their universe.

Many managers adopt the same investment universe as the MSCI World benchmark, around 1,900 stocks from 23 countries.

However, few investors realise that there are more than 15,000 investable stocks listed on public exchanges from over 50 countries.

So what should investors look for when investing in the global equity asset class?

I’d argue that a commonsense approach would serve investors better than many approaches adopted by professional money managers today. Let’s start with a blank sheet of paper and adopt an approach that:

> scours the world for every possible opportunity;

> only invests in attractively-priced companies, that is, a value-based approach; and

> diversifies in order to limit the risk of an individual investment blowing up, that is, it would not be a concentrated portfolio.

You’ll note that the words ‘benchmark’ and ‘market cap’ don’t appear in the list.

This approach would result in a large portfolio of stocks of companies of all sizes and would look very different from almost every other global equity portfolio on offer today, which are constrained by their benchmarks and tend to be dominated by mega and large cap stocks.

Although there is nothing groundbreaking in this approach, it is remarkable that few managers have the courage to deviate too far from their benchmarks.

However, we have found that this commonsense approach outperforms typical benchmarks by a significant margin over time.

My prediction is that we are going to see some examples of these radically new investment approaches over the coming years and potentially even the blurring of the distinction between international and domestic equity investing altogether. Watch this space.

Greg Cooper is the chief executive of SchroderInvestmentManagement .