International equities strategies have traditionally been used as a way to diversify stock portfolios, and thus reduce the risk of losing money. But in a market cycle where everything goes down, there are few places to hide. The Great Recession, as the current downturn has been dubbed, has scared away investors from equities, both locally and international.
In fact, when comparing line charts of the MSCI World Index (excluding emerging markets) with the S&P/ASX 200 Index since the start of the global downturn, it is shocking to see how similar they look. Despite the fact the Australian index has a much higher exposure to the resources and financial sectors than the world index, their charts show an almost identical development over the course of the financial crisis.
In terms of relative performance, the two indices differ slightly. The MSCI World Index fell 55 per cent between October 2007 and February 2009, while the ASX 200 Index declined 50 per cent.
Although there is evidence of decoupling on a macro-economic level, global stock markets are still very much aligned with developments in the United States. Stock markets outside the US, including our own, were not immune to the sub-prime mortgage crisis, despite their strong domestic economies. Global markets have never been so interconnected as today, and they have all been halved in the past 18 months.
But investors would still have benefited from adopting an international equities strategy, Perpetual group executive of global equities Emilio Gonzalez says. Currencies around the world have been affected differently by the financial crisis and this has cushioned some of the falls of overseas investments by Australian investors.
"One of the lessons coming out of the past 12 months is that international equities are a very good diversifier in the portfolio, particularly when the domestic market is under stress, because the currency exposure actually works in your favour," Gonzalez says.
"When the Australian market suffers, generally resources are off, growth is off, interest rates have come off - all the things that are negative for the Australian dollar. That was demonstrated to us recently when the Aussie dollar fell by more than 30 per cent, and the overseas markets actually performed better [than the Australian market]."
But in a climate where investors are fearful to invest even in domestic equities, it is hard to convince them to allocate funds to overseas markets.
"One of the challenges for international equities is getting the confidence from the market that overseas investment is an important part of your portfolio. Because they haven't performed that well relative to the domestic market over the last five years, however, the previous 50 years before that they did quite well. [International equities] are really valuable when the Australian market comes under pressure through the resources side," Gonzalez says.
An active approach
An undeniable benefit of international equities strategies is they open the doors to a vast investment universe and the world's largest brands. The Australian market forms 2 per cent of global stock markets and logically speaking most opportunities lay beyond our national borders. But the challenge of having such a large investment spectrum is that identifying the right companies requires more research, especially in a bear market.
"There are 5200 companies in our universe and in the last months 560 of those had a performance greater than zero," Security Global Investors (SGI) global equities portfolio manager David Whittall said.
"That means 10.7 per cent of stocks are up in the world. One of the challenges is how to direct our research so that you identify those companies that are up."
SGI recently teamed with Bennelong Funds Management for the distribution of its global equity fund to Australian and New Zealand investors.
Whittall says another challenge is the high level of volatility currently dominating the markets. "We have seen the swiftest bear market rally as any of us have seen in our career. We may be experiencing this type of volatility for the remainder of the year or, in fact, permanently," he says.
But even in the direst of circumstances, there are still good companies with solid fundamentals out there, he says. His portfolio includes search engine Google, which also owns YouTube. "YouTube is becoming an asset that is starting to see real revenue growth," he says.
The company has been benefiting from the migration of advertisement from print to the Internet, while it does not have any major debts to refinance.
Fidelity Global Equities Fund portfolio manager Brenda Reed says the financial crisis means she has shifted the emphasis in her company analysis from earnings to assets. "Typically in up cycles we focus on earnings. However, with contracting GDP [gross domestic product] growth worldwide, relying on earnings-related measures is going to be difficult," Reed says.
In previous market downturns, she has done well by looking at price-to-book values, which consider whether a company can generate higher, lower, or the same amount of returns on its asset base as it has done in previous cycles.
"If I think a stock is trading at a multiple of assets that looks cheap relative to what I think the company can earn through a full economic cycle, then it is the type of stock I want to own going into the next up cycle," she says.
"There are some absolutely great investment opportunities out there.
"[But] while some great companies are trading at extremely cheap prices, their earnings for the next year to 18 months won't be good. I will be buying into these stocks over time, ahead of the next cycle."
Wingate Asset Management chief investment officer Chad Padowitz, who runs the Australian Unity Investment Wingate Global Equity Income Fund, has a large proportion of his portfolio invested in oil and oil-related companies.
"At the current oil prices the downside risks to the oil valuations are very low, while the upside potential is quite significant," Padowitz says.
"We don't require consumer spending to pick up or a lot of the fixes that are required for other industries."
The decline in oil reserves also provides a natural driver behind a higher oil price in the long term, he says.
One of the fund's largest holdings is in oil company Petrobras. The fact the company is located in Brazil, one of the fast-growing BRIC (Brazil, Russia, India, China) economies, did not play a part in Padowitz's decision to invest. "Their performance is dictated by the global demand for oil, not by the Brazilian economy," he says.
Whittall, Reed and Padowitz are active managers, who scour the world for investment opportunities. They invest based on a company's fundamentals rather than macro or sectoral considerations, an approach referred to by fund managers as 'bottom up'. Whittall says the financial crisis has made the demand for such funds only stronger. He says he believes the generally accepted notion that the average annual return of equity indices over 10 years is about 10 per cent is being challenged.
"The 10-year buy-and-hold return for the Dow Jones Industrial Average is currently zero. This is leading fiduciaries to reconsider allocations to passive mandates and to mega-cap managers who claimed to be active but have in fact delivered the benchmark at best. The result is an increasing appreciation for active managers with a demonstrated ability to deliver consistent excess risk adjusted returns," he says.
Tracking the index
But there is also evidence the crisis has made investors shy away from actively-managed funds and move into index funds and exchange-traded funds (ETF). After all, not all active funds have been able to beat the index. Some have even substantially underperformed the index. At least with an index fund you know you are not doing worse than the market, or so is the rationale of those investors who have switched funds.
"We have seen a resurgence of indexing due to the instability in markets," State Street Asia-Pacific head of global structured products Susan Darroch says.
"I think there is a little bit of disappointment, especially after fees and taxes, with the returns active manager have been able to provide.
With ETFs and index products, investors know they are going to get the returns of the market and are paying low fees."
ETFs - securities that trade like stocks, but are based on existing indices or commodities - have attracted much attention in recent years. Since the first ETF was launched in the US in 1993, the global market for these securities has grown to almost $660 billion as at the end of January 2009, according to research by Barclays Global Investors. There are 2683 listings on 42 stock exchanges around the world.
State Street offers three of these products in the Australian market, which track local indices, and many more in the US. Darroch says interest in ETFs has grown, partly as a result of a push to reduce management fees. "There is a huge increase in the use of ETFs. ETFs are an extremely cheap way to get a diversified portfolio. For SMSFs, for example, it's a great core for the portfolio," she says.
This trend is confirmed by ETF Securities sales executive Nigel Phelan. "We see a lot of money flow out of active managed funds and structured products into ETFs," Phelan says.
He predicts the ETF market is really going to boom in the next six to 12 months, helped by their transparency and investor disappointment in active funds. "It is very difficult to beat an index, and if you pay 4-5 per cent in upfront fees, then it is becoming very difficult," he says.
The largest provider of ETFs is iShares - a company still owned by Barclays Global Investors, although it is in the process of being sold to private equity firm CVC Capital Partners. It offers about 20 ETFs, which mainly track US indices.
But competitors have been quick to set up shop in Australia, and another player about to enter the ETF market is index fund manager Vanguard, which announced the launch of ETFs in Australia in March.
Although ETFs offer the same diversity as index funds at a cheaper price, Vanguard Investments Australia managing director Jeremy Duffield is not afraid these products will cannibalise the demand for their existing funds.
"We see the funds appealing to different types of investors," Duffield says.
"For example, the exchange-traded funds will be very appealing to investors who have a brokerage account and are interested in getting immediate access to the index funds through the exchange-traded vehicles.
"[But] many of our clients don't have brokerage accounts; they prefer to deal with us directly. And advisers will prefer to invest through platforms, in which case they will invest in our traditional funds."
The suitability of ETFs also depends on how much a client has to invest and how regularly they want to invest. "If they want to invest on a regular basis, paying brokerage fees might not be as appealing to them," Duffield says.
"It's a horses for courses. If somebody wants to be a trader there is no question that the ETF is the better vehicle."
Similarly, index funds are unsuitable for this type of investor. "We discourage market timing in our regular funds. But if they want to be a short-term investor, the ETF might be a perfectly suited for them," Duffield says.
He points to the US, where ETFs have proven to be an investment product in their own right and have not noticeably impacted on the demand for index funds. The idea is ETFs expand the market for index funds, he says. Vanguard has not announced the finer details of their ETF products yet, but is likely to do so shortly, he says.
Looking for recovery
For demand for international equities strategies to return, stock markets will first need to show a clear recovery. Since early March, markets have started to bounce back, but it remains to be seen how sustainable this rally is. A recovery is always preceded by false rallies, or 'sucker rallies' as they are colloquially known for the lack of backing by fundamental data. It is impossible to tell when the real recovery sets in.
The current downturn became the longest since World War II when it entered its 17th month in April. Yet, the outlook for the global economy is still not rosy, Whittall says.
He sees many dark clouds looming, of which the largest are formed by a rise in unemployment in the US. He estimates the US jobless figure will increase from the current 8 per cent to 12 per cent. This is the result of an imbalance in the US employment market that has developed in recent years.
The level of construction workers in the US economy as a percentage of the total of goods-producing workers has risen to almost 35 per cent. As the financial crisis set in, the construction levels have dropped and this will result in mass unemployment in the construction sector. This will then have a flow-on effect on other industries, as these workers will consume less and will not be able to pay their mortgages.
"The forces behind the unbalance in the US economy cannot be unwound in 15 months," Whittall says.
The US will take years to recover, he predicts, and subsequently other global economies will too. He denies his view is too pessimistic. "I don't think it is a worst-case scenario; I think it is a plausible scenario," he says.
Padowitz is less pessimistic, but is also careful not to read too much into the March rally. "What we have seen is confidence that it is not a good time to sell. That's the best I can offer. People don't want to miss the chance to get up and the chance of an upside outweighs the chance of a downside. I don't know if we have moved all the way to the now-is-the-time-to-put-in-new-money stage."
