One of the toughest decisions dealer groups currently face in terms of portfolio construction is how much of clients' money should be allocated to Australian equities versus offshore stocks.
Although share markets globally are sharply higher than they were during the depths of the financial crisis in early 2009, they have gone nowhere in the past six months.
While that is certainly frustrating for investors, it gives the research committees of dealer groups a good window of opportunity to make sure their clients' portfolios are well positioned for the next several years.
Last month, the United States-based chief economist of global financial services giant State Street Global Advisors, Chris Probyn, weighed into the topical 'global versus local' debate with a daring paper titled "Why Australian Retail Investors Should Stay at Home".
Probyn argues that although Australia makes up a tiny part of the world share market, it has one of the soundest economies and also boasts some of the best investment opportunities.
"Australia is just 8.2 per cent of the MSCI EAFE (Europe, Australasia and Far East) Index, 3.7 per cent of the MSCI World Index and 3.2 per cent of the MSCI All-Country Index," he says.
"Australian equity investors may then believe they need overseas exposure to obtain an appropriate level of portfolio diversification. However, recent economic performance and near-term prospects support a degree of home-country bias."
He praises Australia's "remarkable resilience" as it was the only developed economy to dodge a recession amid the global financial crisis and still keep its public finances relatively strong.
"Its public-sector debt to GDP (gross domestic product) ratio is only 22 per cent, far below every G7 (Group of Seven) country, and well below the 90 per cent threshold generally considered detrimental to capital formation and economic growth," he says.
"The direction of trade continues to improve, with Australia now shipping around 25 per cent of its total exports to the fast-growing Chinese economy, up from just 5 per cent in 2000."
Thanks to such attributes and the fact private consumption remains strong while unemployment continues to decline, the economy should forge ahead.
"Australia should grow robustly over the next five years, primarily because of its high potential growth rate, although the output gap will also close further," Probyn says.
"GDP is forecast to rise at an average 3.4 per cent through 2014, more than any G7 country. Inflation should settle around 2.5 per cent, the current account deficit should continue to hover just above 4 per cent and the budget shortfall should disappear.
"Australia's system of franking credits also provides support for a degree of home bias. Franking credits can be worth 1 per cent to 1.5 per cent a year to Australian resident investors with an Australian index equity portfolio."
State Street Global Advisors expects Australian equities to return an annualised 7 per cent over the next five years. Probyn believes there is value particularly in the local banks and cyclical industrial stocks as they have underperformed since the market volatility began in April.
"Mining also appears attractive as it trades at less than 10 times one-year forward earnings and commodity prices should grind higher along with the global economy," he says.
"Looking at the economic backdrop, the financial backdrop and taxation issues, there are good grounds for a degree of home bias in the portfolios built by Australian investors."
While Probyn puts forward a strong case, not everyone subscribes to the theory that a robust economy means booming stock market returns.
"I would point out that correlation of equity returns with GDP growth is very low," Vanguard Investments global chief investment officer Gus Sauter says.
To illustrate the point, he says that in the 20th century, the US and the United Kingdom experienced annualised GDP expansion of 3.2 per cent and 1.8 per cent respectively.
However, despite the US's faster growth, both countries' stock markets returned 10.1 per cent a year on average over the period.
"So economic growth or GDP growth is not a great predicator of equity returns," Sauter says.
"And the reason for that is financial theory tells us we are being compensated for the risk we take; we are not being compensated for the growth of the underlying investment."
He believes returns from global equities will be attractive if investors take a long-term view.
"We do think that the highest correlation you will find with market returns is really starting [with] price-earnings and earnings growth," he says.
"We think the starting price-earnings points are attractive now. Really, on a developed world basis and actually in developing world markets, the average price-earnings is 11 times next year's earnings.
"So [given the] historical average is 15 times it means things are attractive. If price-earnings ratios expand from 11 times to 15 times, you have almost a 40 per cent return just to get back to average."
Zurich Investments senior investment specialist Patrick Noble agrees that investors need to think about how much they are paying for assets as a starting point with any type of investment.
"Economic growth can provide a tailwind for earnings, but the market will tend to look forward and assess whether that growth is sustainable and more importantly whether the price you are prepared to pay for it is justified," Noble says. "If you buy something at the height of the valuation, you're not going to get as strong a return."
He says there currently is not a wide discrepancy between local and global equities.
"In fact, we would argue that global equities might even be a little cheaper and there is more of a home bias to holding Australian equities at the moment," he says.
The Zurich Investments Managed Growth Fund was overweight both asset classes as at August, with international shares making up 27.9 per cent of the fund's asset allocation and Australian equities making up 36.9 per cent.
The $163 million fund is betting on international managers such as Lazard Asset Management and American Century Investment Management.
Noble says the old arguments around diversification still make sense and are sound reasons for investing in global equities.
"Our economy is pretty much reliant on one pillar of growth, which is China, and while this is providing attractive opportunities for growth in sectors such as materials, other sectors are finding the going a little tougher," he says.
"We think there are very strong companies with compelling valuations overseas, but would encourage investors not to chase the performance of companies with weaker balance sheets when the market is going through a period of 'risk on'.
"The types of companies we like are the ones that won't get too impacted by the prevailing economic conditions. A large number of these companies are sitting on huge amounts of cash on their balance sheets and it's one of the opportunities that we feel has been discounted by investors."
He points to Microsoft as an example. The software giant generates more than $20 billion in operating cash flow each year.
"It has $30 billion in cash on its balance sheet and the market is asking 'what are you going to do with that money?'" Noble says.
"If the ability to reinvest it profitably is limited, we would expect good management to engage in attractive capital management programs.
"Microsoft does this via large share buybacks and also by dividend payments. In a low-growth environment, dividends will be an attractive source of return for investors."
Suncorp Life head of research Michael Furey also favours global equities.
"While there is a belief that our economy is stronger than the major developed economies, there is a fairly weak correlation between economic strength and stock market strength unless prices are very low, which they are not," Furey says. "My personal opinion is that I'm probably more inclined to favour global equities over Australian equities. I think there is a greater opportunity set offshore and therefore more diversification to reduce portfolio risk.
"And from a downside risk perspective there is probably greater downside risk in the Australian share market than there is in the combined global share market because of the heavy weightings of banks and material companies."
Financials make up nearly 40 per cent of the S&P/ASX 200 Index, while materials companies make up 25.5 per cent.
Furey says local banks are exposed to significant risk if Australia does indeed have a housing bubble and that bubble bursts.
"On the housing bubble there was [fund manager GMO's co-founder] Jeremy Grantham, one of the most respected fund managers in the world, who recently said that our housing bubble is one of the only bubbles left in the world," he says.
"I don't necessarily agree with it being in a bubble, although I do acknowledge our prices are very, very high, but if it happens, it poses big risks to our banks."
The resources industry also faces downside risk if China in particular slows down, he says.
"They have an absolutely booming economy, but there is lots of talk around China slowing the rate of growth and that could have a significant impact for our resources exports because of the expected growth that is already factored into prices," he says.
Research house Standard & Poor's (S&P) director of wealth management Jeff Mitchell shares the concerns about Australia's dependence on China.
"For equities, Australian investors and portfolio construction has generally favoured a larger Australian exposure rather than international equities," Mitchell says.
"In our view while the outlook for the materials-dominated Australian market remains buoyant due to the demand for resources being fuelled by the ongoing industrialisation of China and other emerging economies, the risks to the Australian market and economy to ongoing strength of Chinese industrialisation is high.
"Therefore we are comfortable to see an increase in the global equities exposure in portfolios to diversify Australian-based equity portfolios to this potential risk."
Russell Investments portfolio manager Andrew Sneddon is keeping a close eye on such potential risks, but is actively managing the Russell Balanced Fund's position on domestic equities and global shares.
"One variable that I caution cannot be seen as a given going forward is the strength of the domestic economy," Sneddon says.
"Domestic equities have done well and they have done well relative to global equities over long time horizons. Is that likely to change from now and Christmas? Probably not. "But will it always be the case? I would suggest that it would be dangerous to make that assumption, so in terms of the portfolios I build it will be important to have a role for both domestic and global equities.
"There are going to be times when we want to down-weight our domestic equities exposure. It is not right now, but there will be times we will want to do it."
He says if there is to be any reversal of the trends that have allowed the Australian economy to remain strong, such as the strength of China and demand for local resources, then investors can expect an Australia-specific downturn and weakness in domestic equities.
"So right now we are happy to have a higher strategic allocation to domestic than global, but I think you want to be responsive to the macro environment and valuations and that's how we're actively managing our funds," he says.
The $1.2 billion Russell Balanced Fund has more than 30 per cent of its assets invested in Australian shares and a high 20 percentage-point exposure to global equities.
In the Australian component of the fund, Sneddon is betting on managers including Perennial Value, AllianceBernstein and Orion Asset Management.
The international equities part is exposed to Snow Capital and MFS Investment Managers and also has a big position in the Russell Emerging Markets Fund, which invests in developing nations' equities via managers including UBS Global Asset Management and Arrowstreet.
"In our international shares exposure we have an overweight to technology and emerging markets. We think emerging markets exposure will be very important," Sneddon says.
"There are projections that the investable universe of emerging markets stocks will rise from the mid-teens to potentially the 30 per cent mark over the next few years, so we think access to those markets are going to be very important as they are going to enjoy higher economic growth rates and considerably stronger sovereign balance sheets.
"Going into 2011 I think you will see us make emerging markets a bigger part of our strategic allocation within global equities."
