It seems really hard to believe that just 25 years ago the concept of international investing was foreign to a large percentage of the US investing public. I remember the time well: in 1986 I was assigned to the Tokyo office of a large US investment bank, a move that had my New York colleagues shaking their heads wondering what value I could possibly gain from working in such an exotic outpost, so far from the pulsating heartbeat of the world financial system in downtown New York. How times have changed. These days it is not possible to wade too far into the market without confronting a staggering variety of ways to obtain exposure to virtually any region, country, investment sector or theme anywhere in the world. International investing is no longer exotic: it is required.
But what are you actually buying when you go international, and how do you put together an investment strategy that makes sense in light of the dynamic pace of the markets evolution? There is no one single answer to that question. Kevin Cimring provided a useful view into a part of this question in a posting last week entitled Investing in Emerging Market ETFs addressing both an asset class (emerging markets) and an investment vehicle (ETFs) of growing importance.
The purpose of this post is to take a step back and look at the broader picture. The terminology associated with international investing can be complicated and confusing. It is important to understand what you are getting into, because there are profound risk and return considerations for your portfolio depending on what waters you venture into.
The traditional nomenclature and by traditional I really mean what evolved to become standard practice over the course of the 1990s and into the first decade of this century is divided into three parts (and forgive me for taking a US-centric approach here but that is my frame of reference): domestic, international and emerging markets. Domestic meant the US equities and debt markets, international really meant the developed markets of Western Europe, Japan and a couple Asia Pacific spots like Australia and Hong Kong, and emerging markets were those up-and-coming dynamos like China, India and Brazil. A typical manager of diversified investment portfolios might have an allocation among all equities holdings of something like: 65% domestic, 30% international (i.e. developed)and 5% emerging markets, reflecting the trade-offs between expected return, risk and the level of correlation between the different asset classes.
There are some fundamental problems with this traditional approach that make it unsuitable for todays environment. Lets start with the relationship between domestic (US) and developed international markets. 20 years ago, it was possible to obtain meaningful diversification benefits from investing in non-US assets, and that was one of the primary allures that got more and more investment managers looking beyond their traditional domestic confines. The correlation between stock markets in, say, Great Britain or Germany and those of the US were low enough to provide a meaningful source of value to US portfolios (low correlation between assets in a portfolio is a highly sought-after characteristic).
That is not really the case anymore, for a few reasons. For a start, the world has become much more globalized. Look at the composition of the US S&P 500 index, a broad market indicator containing 500 of the largest companies domiciled in the US. Domiciled, yes but if you look at where these companies are doing business you find that across many different industry sectors the leading companies are truly global they are deriving up to 50% or even more of their revenue from non-US sources, having exposure to multiple foreign currencies in multiple economic environments. The same is true for the largest companies in Germany, the Netherlands or Hong Kong. So making some arbitrary division between the percentage of US and developed international assets for a portfolio is more than a bit simplistic. An added level of analysis is required for example, concentrating certain exposures in small-cap stocks (which tend to command less of a global presence due to their size), or even more so in real estate (such as REITs), which remains the ultimate local business.
Then we come to emerging markets. Here is where the world really has changed. China recently overtook Japan as the second-largest economy in the world, Brazil has rapidly moved up the value chain as a sophisticated and globally important economy, and the so-called emerging Asia region is on course to become the fastest-growing and most influential economic region in the world. Maintaining a traditional cap of 5% or so to your emerging markets exposure is simply out of step with the percentage of global wealth that exists in these markets (and continues to expand).
Morgan Stanley Capital International (MSCI), a long-standing operator of international index benchmarks, recently revised its designation of countries from developed and emerging to add a third category frontier. Frontier markets are today what emerging markets like Taiwan and Malaysia were 20 years ago a wild ride of potentially outsize returns and, commensurately, outsize risks. These are countries like Ghana, Ukraine, Bulgaria and Vietnam exhibiting great potential for growth but still young with relatively undeveloped legal, market and political infrastructures. They really do not belong in the same tier of risk/return positioning as global engines like China and Brazil, even less so emerged markets like Chile or Malaysia that in many ways are indistinguishable from middle-tier Western European countries like Sweden or Belgium when you look at risk-return performance over recent years.
As a rule of thumb I am inclined to believe that for the equities portion of a moderately growth-oriented portfolio (i.e. looking for opportunities for capital appreciation without taking too much out-there risk), something along these lines might make sense: 50% allocated among US and other mature markets in Western Europe and the Pacific Rim, 35% allocated among the growth markets formerly known as emerging markets, and 15% spread among a diversified pool of the frontier markets that show up in the MSCI Frontier Markets Index. Those percentages are highly elastic and any investor needs to consider his or her own return objectives, risk tolerance and special circumstances very carefully before making any portfolio allocation decisions but they can serve as a guidepost for making sense of the new global economy. For More Information Please Visit:
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