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Reorienting Portfolios for a New World

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In the bestseller “The World Is Flat: A Brief History of the 21st Century,” Thomas Friedman argued that the world is now a more level playing field than it has ever been in history. As a result, geographic divisions are increasingly irrelevant.

We concur with that assessment and believe that it has ramifications for how portfolios are (or should be) constructed. And we aren’t alone. There is evidence that institutional investors have been of this mindset for a while now, as pointed out in a 2010 study by MSCI Barra that concluded “global equity mandates […] may be emerging as the ‘new classic’ structure for implementing equity allocations.”

While institutions have been migrating away from regional mandates in favor of global mandates, individual investors have been slow to follow their lead. We believe advisors need to help investors increase their adoption of globally oriented strategies.

Consider the data in the above table. Two things are immediately clear from these numbers. First, global equity funds are far from mainstream, with only a 6% market share across these categories. Second, assuming that assets in U.S. and international funds are a good proxy for a typical investor’s equity allocation, there is a large home country bias. The weighting to the U.S. within the MSCI World Index is approximately 59%, so a market-weighted portfolio would have a similar exposure to U.S. equities. However, that is not what we see in the data; U.S. equities make up a disproportionate 80% of the assets in the two categories.

So why do we believe that investors should consider allocating to global strategies? For one, global markets have become considerably more integrated over the last few decades. As a result, industry factors now dominate country factors in terms of explaining stock market returns, a 2000 paper in Financial Analysts Journal found. Additionally, most mid- to large-cap companies now generate substantial revenue abroad. In fact, overseas revenues of S&P 500 companies exceeded 48% in 2014, according to S&P Dow Jones Indices. Where a company domiciles is much less relevant than it used to be.

Another benefit of a global focus is the improved opportunity set. An analyst covering semiconductors, for example, needs to have a view not only of U.S.-based firms like Intel, Micron Technology and AMD, but also Samsung and SK Hynix in South Korea, STMicroelectronics in France and Infineon Technologies in Germany, to name a few. If that analyst is going to do the work to form views on these geographically diverse firms, why artificially constrain the buy decision to U.S. firms? European firms? Asian firms? Doing so introduces information leakage into the investment process.

It may also be advantageous to employ global managers in order to simplify asset allocation and portfolio construction processes. The more granular the mandate (think U.S. mid-cap value as opposed to U.S. equity), the more granular the capital market assumptions need to be, which adds complexity and increases sources of error. Further, as investors have come to understand and include an increasing number of asset classes and strategies when constructing portfolios, the number of managers utilized has ballooned. Portfolios were quite simple when investors mainly allocated to U.S. equities, international equities and investment-grade bonds. Now it’s common for even retail investors to have exposure to TIPS, emerging market equities, real estate and a host of alternatives. While we believe in broadly diversifying across asset classes, geographies and strategy types, doing so results in significant complexity that can make it difficult to understand the true risk exposures within a portfolio. That complexity can be lessened in part by employing a smaller number of globally focused managers.

Finally, due diligence, properly done, is a resource-intensive process, so if you are going to do the work to identify skilled managers, why artificially constrain them once identified? By making larger allocations to fewer high-conviction, geographically unconstrained managers, both the initial search costs and the ongoing monitoring costs are lessened. Additionally, allocating more money to fewer managers allows for the possibility of reduced costs through the ability to access institutional share classes of mutual funds and declining fee schedules for separately managed accounts.

— Read “Global Investors Sitting on ‘Mountain of Cash’: BofA Merrill Survey” on ThinkAdvisor. 


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