Equities: Going global
The blurring of lines between developed and emerging markets have made global equities a tricky investment zone, but that doesn’t mean there aren’t lucrative opportunities for planners with the right knowledge, as Janine Mace explains.
We live in a rapidly globalising world. While everyone knows it, sometimes it’s easy to forget the implications of this.
For advisers and clients, the path to investing successfully in global equities has never been simple, but now it’s getting just that little bit harder.
Whether it’s where your fund selects its investments, or the benchmark it uses, attitudes and approaches are changing.
Advisers need to ensure they understand what these trends mean if they are to use the asset class to its best advantage for clients, according to Bronwen Moncrieff, head of research at Zenith Investment Partners.
“It is important for planners to understand global equity funds are changing. In the future you may just have a global manager, not a developed market or emerging market manager. This has important implications in constructing portfolios and asset allocation,” she says.
According to Lonsec senior investment analyst, Rui Fernandes, there are important shifts occurring in the global equities investment market, providing greater choice and new access. “There is an increased responsibility for financial planners to know which option is going to meet the need of their clients in terms of individual risk appetite and desired investment outcomes.”
One of the major drivers behind these shifts is the increased blurring of the division between developed and emerging markets. Many large multinationals now achieve more revenue and growth in emerging market countries than their traditional home market.
“The question now for investors is, does it matter where the company is domiciled? From a company performance perspective, this is not as important anymore and is less relevant,” Moncrieff explains.
“Increasingly, managers are researching where the company’s underlying revenue is generated. Many developed market domiciled companies’ strategic plan is now based on revenue growth from their emerging market operations.”
This transfer of economic and revenue growth is reflected in the shifting composition of the key indices used to construct global equities funds. In the MSCI All Country World Index (ACWI) for example, Zenith research has found 36 per cent of company revenues in the index were generated in the US in 2006, but this is now down to 30 per cent. On the flip side, 18 per cent of revenue was generated in emerging and frontier markets in 2006, but this rose to 32 per cent in 2013.
“There has been a big change in economic exposure and this shift is being reflected within global equities products,” Moncrieff explains.
Lonsec’s 2014 Global Equities Sector Review noted the impact of this on product development. “A distinct flavour to this year’s crop of new products/managers has been the general indifference to the industry fixation about choosing developed or emerging markets.”
In addition, many funds are lifting their explicit strategic allocation to emerging markets.
“Most investment mandates eight to 10 years ago referred to a 10 per cent emerging market exposure, but in 2013 it is more likely to be 20 per cent to 30 per cent. In retail global equity funds now, it is not unusual to have 30 per cent in emerging markets,” Moncrieff notes.
Restructuring products and teams
With geography becoming increasingly irrelevant, many global equities managers now focus on picking the best companies in a particular sector, rather than making selections based on the relative attractiveness of a country’s economy.
“In the past it was a country allocation, then a regional decision and now it has moved to being about the sector,” Moncrieff explains.
“The global perspective creates an increased opportunity set for managers to select from and they can select the best. This broader choice is valuable to managers in terms of generation returns.”
In response to the new emphasis on sector – rather than geography and top down factors – many managers are restructuring their investment teams.
“They have changed their internal structures, as they now look at the market in a true global sense. Planners need to recognise and understand this change,” Moncrieff says.
Although managers may enjoy the opportunity to back the companies they believe in – wherever they are domiciled – it does have important implications for clients and advisers.
“Managers largely are more unconstrained or very broadly constrained and are not limited to where they can go any more. The extension of this trend is that many managers have changed the benchmark they use moving from MSCI World to MSCI ACWI,” Moncrieff notes.
“If you are a global manager and not in Australia already but are coming here for a product launch, mostly you would be using MSCI ACWI, as it reflects the managers’ view of the market now.”
Stuart James, senior investment specialist at Aberdeen Asset Management, agrees managers are rethinking their approach. “Planners need to be aware of how they are getting exposure to global markets. It is about being selective with your global equity funds.”
Advisers need to take a closer look at their fund of choice, he says. “It may not be obvious what the manager is using as a benchmark, so I would encourage advisers to go back and look at what benchmark their manager is using, as they may be getting heavy exposure to an overvalued market. For example in the MSCI World Index, the US market represents 50 per cent of the benchmark.”
Taking bigger bets
Global equity products are also evolving to become far more concentrated, as managers seek out the best companies globally. As the Lonsec review noted: “More concentrated offerings with less than 50 holdings have flourished. This is profound and has heralded a distinct shift away from approaches with highly diversified portfolios.”
Strong performances by some very concentrated global equity funds has given further credence to this style of investing. For example, the Magellan Global Fund contains only 20 to 40 names, but has enjoyed both good performance and inflows.
“Some managers have been very successful with products with very concentrated portfolios and this has resonated with investors more generally,” notes Fernandes.
In addition to greater concentration, the mandates of many funds include broader risk constraints and allow greater flexibility than in the past.
“This is allowing the management teams to implement their views. Five to 10 years ago global products were more benchmark aware and had a tight tracking error, but since the GFC, and particularly in the past year or so, there has been a different take on that,” Fernandes says.
The trend towards more concentrated funds is due in part to the continuing popularity of index products.
“Investors are asking why they are paying active fees for benchmark returns. They are increasingly interested in index-like return products, as they do not want to pay active fees for beta. This has led some active product managers to rethink what they do and the products they are offering,” Fernandes explains.
James believes this is an important point for planners. “Don’t be fooled. Advisers need to look at what is the benchmark and what is the long-term performance of the fund. They need to ensure they don’t pay active fees for closet benchmark-hugging managers.”
If all this isn’t enough, managers are also tweaking their products in other ways.
Several products launched in the past year have taken a thematic approach to their investments. This sees top-down elements being applied through prioritising the stock research agenda or influencing portfolio construction, the Lonsec review notes.
“The new products are quite different to old products as they are more thematic, have less names in the product and are more concentrated,” Fernandes says.
Know your client
Overall, experts see the changes to global equity funds as good, as they give advisers more choice.
“Institutions can have anything they want, but retail investors have been constrained in the products available to them. We think it is good for the sector and it gives an increased ability to advisers to seek out products that fit what their clients need,” Fernandes notes.
Advisers, however, will need to do their homework.
“The changes mean an already complicated sector is now a bit more complicated and this means planners need to spend a bit more time on understanding the products that are available,” he says.
“They need to survey the product landscape, understand what is available and that the products are now quite different. There are many more options available now.”
This may require clients to be re-educated and funds re assessed to ensure they still fit the necessary risk profile.
“It is important for financial planners to recognise that the move away from low tracking error to a greater focus on absolute returns will lead to different results. This can be very different to the benchmark and it may lead to difficult conversations with clients. If the manager is holding different sectors, planners need to understand what that means,” Fernandes notes.
“They need to know their client and what they want, and this leads to product selection. For example, if you have a risk averse client who is very concerned with downside risk, they can invest in global equities, but you need to pick an appropriately managed product.”
Roy Maslen, AllianceBernstein’s chief investment officer Australian value equities, agrees advisers need to think carefully before they select products in this space.
“An important consideration when thinking about an allocation to global equities is what kind of global equities do investors need? Do they want high return seeking or risk reducing? A global value strategy, for example, or low-volatility equities?” he notes.
“The financial risk profile – such as where investors are on the path to saving for, and transitioning into, retirement – will come into that.”
Chris Marx, AllianceBernstein’s New York-based portfolio manager for low volatility equities, believes most Australian investors should have some level of global exposure to improve the diversification within their portfolio.
“Australians are fairly sophisticated investors, but the economy is relatively concentrated in a few sectors. It’s hard to get a lot of tech holdings, for example, in Australia. So if investors want to get exposure to some of those other sectors, they need to own stocks in other countries,” he says.
Although many local investors have an understandable bias towards investing locally, James agrees the argument for invest offshore is compelling. “Home country bias is everywhere, but in Australia we have a narrow market centred on banking and resources, so there is always a strong case for looking offshore.”
Strong global returns
The value of investing in global equities has been very clear over the past 12 months, with returns from the asset class outperforming most other investments, Marx notes. “In broad terms, depending on which currency or market you reference, markets were up anywhere from 25-30 per cent last year, and they’ve been up a few percent this year.”
Over the 12 months to March 2014, the MSCI ACWI ex Australia returned 32.19 per cent, while the MSCI World ex Australia returned 35.26 per cent. The average manager in the Lonsec universe returned 32.15 per cent, with the ASX200 trailing a long way behind in the low teens.
According to James, developed markets were the strongest performers, with emerging markets turning in a much weaker result, which is currently continuing. “We are seeing two-speed market returns at the moment and it is a switch over from the past few years, where emerging markets were stronger.”
Looking ahead, most experts remain positive about global equities, although there are some notes of caution appearing.
“There is a lot to be positive about global equities, as the US and Europe are recovering. There has been a slowdown in China, but it is still quite strong growth compared to the developed markets,” Moncrieff notes.
The outlook for the Australian currency is also making global equities attractive for local investors, Maslen says. “The Reserve Bank recently said reduced funding needs on the part of Australian banks and lower levels of foreign investment in the resources sector were likely to put downward pressure on the Australian dollar. On that basis, exposure to global assets over time is likely to benefit from a falling dollar.”
According to Fernandes, Lonsec currently has a neutral weighting for global equities as the asset class offers reasonable value.
From Marx’s perspective, globally equity valuations relative to fixed income are quite attractive. “The equity risk premium is very elevated. With the global economy showing signs of sustainable recovery, we anticipate equities moving more in line with earnings growth. This suggests an increase in the high single digits on an annual basis – not as strong as we saw last year, which was a great year.”
Within the broader asset class, valuations for different sectors vary, he notes. “We see the US market as more fully valued than other regions and Europe and Japan as being more attractively valued, given that their economic recovery is not as far along as that of the US.”
Earnings growth required
One of the main questions around global equities – particularly in the US – is whether or not companies will be able to achieve earnings growth this year.
After last year’s rallies, markets are looking for real earnings to rise before prices are bid up much further. Commentators have been quick to point out that a significant proportion of corporate earnings are coming from cost cutting, rather than growth in underlying earnings.
“There are concerns about this, with US equities in the past three months declining marginally. This year markets have been a lot more subdued,” James says.
“We have also seen equity buy-backs in the US, so there may be concerns about whether there has been some ‘window-dressing’ of US company results.”
Sluggish global growth and low inflation in developed markets is making it hard for companies to pass on price increases, leading to concerns about whether companies can achieve analysts’ growth expectations over the next 12-18 months.
“The data is now softening and not improving as much as markets were expecting,” James notes.
A similar story is playing out in Europe, although there are growing prospects the European Central Bank may introduce some form of stimulus, or even negative interest rates, to get the European economy moving. Japan is also looking at a further bout of stimulus.
“I am more cautious due to the strength of the market last year and that momentum will be hard to maintain. In the developed markets, a lot of hope has been built into valuations. There is a disconnect between market optimism and reality, particularly in the US,” James notes.
Although positive, he believes care is required. “If investors are overweight US and Europe, I would express a word of caution. Global equities are a long-term allocation, but for those investors in MSCI World benchmarked fund, they may want to take some profits off the table. Those on the MSCE All Country Funds can expect some volatility but should take a long-term view.”
By contrast, emerging markets may be appealing. Recent sentiment towards emerging markets has been very negative and they are currently at a 30 per cent discount to their developed market peers.
Market concerns about the so-called ‘Fragile Five’ [India, Indonesia, Brazil, South Africa and Turkey] countries with high current account deficits are ebbing, as has the recent investor rush for the exit.
“A lot of money flowed out of emerging markets in the past 12 months, but this has moderated now,” James notes.
“For braver emerging market investors, there are potentially good returns in prospect, as they appear to be the most attractive opportunity.”
In fact, many emerging markets corporates are better placed than their developed market counterparts. “Emerging market companies are cheaper and many are of better quality. For brave investors, they are looking more attractive,” he says.
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