With the number of exchange traded products continually growing (globally, there are now more than 4,700 ETPs and counting), an interesting debate has arisen about whether investors should gain access to international equity markets through a fund that tracks a broad benchmark or through more granular regional or country exposures. Typically choice is a positive thing, but it’s understandable that the size and scope of the ETP market can add a layer of complexity to an investor’s selection process.
As usual, there is no one right answer, as the choice should be driven by whether or not an investor believes he or she can distinguish between different exposures, like countries or sectors. That said, investors with views on specific regions could certainly consider a more granular implementation, particularly given the recent divergences we’re witnessing in global equity markets.
For most of the past four years, the world has lived in a risk-on/risk-off environment, with investors’ changes in risk tolerance setting prices. While the underlying sources of volatility are unlikely to abate, we are already starting to see more differentiation in performance between different countries and regions. For example, the United States has been a clear winner in 2012, while much of Europe has struggled.
Even within regions, we have seen significant divergences. Europe’s overall performance has masked significant differences between the south and the north. Germany has had a stellar year, while southern Europe has, up until recently, struggled. Similarly, we have witnessed significant differences in emerging market performance, particularly compared to the more homogenous returns of the last several years.
We would expect this differentiation to continue. The next 12 months will witness significant opportunities and risks, many of which will be idiosyncratic to particular parts of the world. Will the United States avoid the fiscal cliff? Will China engineer a soft landing? Whether China or the United States stalls or thrives will be reflected most in their respective equity markets. Given the potential for significant divergence in performance, investors with a view can be well served by having the flexibility to express their outlook in the most granular manner possible.
In addition, there is another potential advantage to a more granular approach. Because each region or country has its own unique risk profile, building an equity portfolio with regional- or country-specific funds can offer the potential for higher risk-adjusted returns. Implementing through regional or country funds allows an investor – even one without a strong view on country performance – to assemble a portfolio that may be better diversified than a traditional cap-weighted benchmark. Through better diversification, we believe that it’s possible for investors to assemble portfolios with a higher return-to-risk ratio.
For investors looking for a diversified, single ticket solution and with no particular views on country performance, a fund based on a broad benchmark can be an appropriate choice. However, both from a return and risk perspective, a more granular implementation may offer more opportunities, particularly if countries start to go their own way – for good or ill.