Growth, Income And Diversification - 3 Reasons To Increase International Equity Weightings

Includes: AXJL, EEM, SPY
by: Far Horizon

Investors tend to focus heavily on their home country when allocating their assets, as this has several advantageous factors in terms of familiarity with the markets, comfort with the legal and financial environment, and association with future liabilities, such as retirement cost for individual investors, and labour, and management costs, or dividend and distribution expectations for institutional investors such as pension funds.

A cautious approach is recommended by the Association of American Individual Investors, who's most aggressive portfolio allocation has 60% in U.S. stocks, 20% in non-U.S. stocks, and 10% in Emerging market stocks, while the moderate risk and conservative risk profiles have almost no emerging market exposures. The AAII website has 3 risk profiles in their allocation section.

This however, does potentially forgo some significant opportunity for returns, and does run the risk of over-correlation of the portfolio, when compared with investing more actively in overseas markets. There are three specific sectors that are currently worth serious consideration for a more adventurous allocation strategy, either in the short/medium terms given the current U.S. market situation, or in the longer term. These would be emerging markets for growth, targeted high-yield markets such as Australia, and Europe for scalable diversification.

In fact, as economic globalization continues, mutual funds and institutional investors have been extending allocations into other regions more actively, with IMF research (pdf) showing that between 2005 and 2010 institutional investors reduced their allocation of equity portfolios to the G7 countries from 88% to 77%.

Geographical allocation on Equities
2010 2008 2007 2005
G7 77% 78% 83% 88%
Asia ex G7 10% 6% 9% 5%
Non G7 advanced 7% 8% 8% 5%
Latin America 4% 2% 3% 1%
Africa/ROW 2% 1% 2% 1%
Source - IMF

While hard data isn't available indicating the U.S. exposure individually, a survey of fund managers in the report indicates that pension funds weighted 50.3% to their own countries, and asset managers a more aggressive 44.8%. This demonstrates a clear trend toward a more global risk profile, and specifically to emerging markets, with 16% in markets categorized as "non advanced," compared with the AAII's most aggressive recommended emerging markets allocation of 11.11% .

Benefits and risks of overseas equity allocation

The IMF survey also explores the rationale behind this, which is predominantly around the diversification, growth and increased yield opportunities available in international markets. To this we should also add value, as recently there has been some significant regional divergence in the price of equities

On the risk side, the main concerns in the IMF survey are country risk, liquidity and volatility, and there is in addition the challenge of lower levels of corporate governance in some markets and a significant currency risk, which needs to be actively managed for international investments. On the currency topic, the current environment is clearly highly influenced by the impact of the Fed's QE activities.

Top Five Factors Considered in Cross-Border Investment

(Ranked by scores)

Asset Managers Pension Funds

  1. Diversification Diversification
  2. Growth prospects Growth prospects
  3. Yield Yield
  4. Country risk Range of investments
  5. Market liquidity Volatility

Source: IMF Survey on Global Asset Allocation

As an investor living in Australia, and working primarily in the Asian and European region, I see many opportunities and specific countries outside the U.S., which the U.S. investor might avoid due to this home bias. In this article I will explore some of these at the high level, consider some of the risk factors, and how to mitigate these, and in future articles will drill down into some specific opportunities, generally touching on individual countries as I physically visit the locations.

Emerging Markets for growth

Any growth-oriented investor will struggle to keep up with global growth rates without a significant allocation to emerging market equities. While currently the emerging markets story centers around very impressive growth rates, the scale of EM economies is still small compared with the developed world - totaling around 37% of the global GDP in 2010, and as a share of emerging markets business is captured by global companies, those based in the emerging markets accounted for only about 31% of market capitalisation and a mere 13% of the MSCI world index.

Projections made by the IMF show the dramatic impact of scalable growth in the emerging markets, with EM's accounting for nearly 60% of both GDP and market capitalisation by 2030. Nevertheless, the relatively smaller size and large number of EM stocks is anticipated to generate 31% of the MSCI world index by that time.

This means that investors who wish to take advantage of the current growth phase of these markets need to gain exposure through direct access to target markets, rather than to try to gain emerging market exposure through companies from developed markets that have a strong EM focus.

International equities for yield

While many U.S. companies have started to respond to shareholders' appetite for dividend income in the current-low yield environment, there is still a significant difference between dividend policies between U.S. companies and those in other markets. Part of this is driven by corporate fashion, and in some cases by different taxation treatment. In Asia, investors in general seek to see income generated from their investments in addition to paper value growth. This is significantly influenced by a past environment of intransparent accounting regimes and poor corporate governance - the investor sees a real and regular return from investments in addition to paper profits. In other markets, such as Australia, there are tax differences that influence payout rates. In Australia a dividend imputation system, which generates tax credits for investors, enables investors paying tax in Australia to avoid double tax on dividend profits. While the "franking credits" of dividends is not available to U.S. taxpayers, this treatment encourages a more progressive dividend policy.

To have some idea of recent dividend yields for example, the Australian MSCI market equivalent (EAFE) tm yield is 5.47%, and on a broad regional basis, consider the yield from Wisdom Tree, Asia Pacific Ex Japan Fund (NYSEARCA:AXJL) at 3.42%. These do look attractive compared with S&P 500 yields such as SPY, although the yields on pure EM ETFs such as EEM haven't recently outperformed SPY.

Diversification impact

As identified above, one of the main considerations stated by asset managers for allocations to international equities is diversification. While there has been considerable convergence of market performance between U.S. and international markets, there remains significant diversification benefit to an international portfolio.

Those wary of international equities will be drawn to the fact that U.S. equities have generally outperformed both European and Emerging market stocks over the recent past, but the diversification impact is the issue to illustrate here. The valuations of many European and EM stocks now look quite attractive compared with the U.S.

The bottom line

Institutional investors are re-weighting their portfolios with a lower allocation to U.S. equities compared with international, especially seeking the growth and dividend income from emerging market stock, coupled with diversification. The individual investor should seriously consider whether this would also be appropriate for them. If so, the risks need to be carefully managed through country, currency and stock selection. Hedging of currency risk is an important consideration. ETFs can play a useful role here, but as these gravitate toward the larger existing stocks, broad ETFs such as EEM could be underweight to the real growth opportunities, and overweight to the existing large players.

With U.S. equities at all-time highs, and significant value gaps to other international markets, 2013 could be a strong window of opportunity to look outside of U.S. equities.

Disclosure: I am long EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.