A little while ago, we spoke with David Garff, the President of Accuvest Global Advisors. David’s responsibilities include oversight of the firm’s asset allocation process, CST investment strategy, country selection model and hedge fund of funds portfolios. He began his investment career in 1992 with Merrill Lynch, and then spent 10 years as a consultant with Smith Barney, serving the needs of affluent families, Foundations and Endowments.
David graduated with a B.A. in Economics and Spanish Translation from Brigham Young University, and a Masters Degree in Business Administration, with a concentration in Finance, from the Haas School of Business at the University of California, Berkeley. He earned the Certified Investment Management Analyst designation as well as an Alternative Investments Certificate, both taught under the joint auspices of the Wharton School of Business, and the Investment Management Consulting Association.
David is a frequent speaker on the subjects of portfolio construction, risk management and country effects in global equity markets. Recently, David wrote an excellent white paper entitled Global Equity Investing: Do Countries Still Matter? which can be read here. After reading this, we spoke with David to hear his thoughts on single country ETFs, emerging market investing, and why many investors can’t seem to shed their home country bias.
ETF Database (ETFdb): David, can you tell us a little bit about your research in the ETF space and particularly your work analyzing individual country markets?
David Garff (NYSE:DG): As you know, in the late '90s, the single country ETFs were available, but there was not a lot of volume there, so it was hard to make any progress in the market. At that time the number of ETFs available was very low, somewhere around 20. What we saw, in 2004, was a real big spike in volume in terms of the non-US ETFs, which was interesting because I had been talking with a client for years about building a portfolio that would be global in nature and avoid some of the pitfalls that we had become accustomed to dealing with.
The expansion of ETFs also allowed us to express our view in a country in a way that took out the need for single security selection. What we saw were managers would have a good call on the country, but would lose a lot of money purely based on the stock selection. So our goal was to employ global thinking, but avoid single security risk.
ETFdb: Why do you think so many investors still have a home country bias? Especially considering how well emerging markets have performed over the last decade or so.
DG: I think people, specifically in the US, are being sort of dragged kicking and screaming into making heavier international allocations, in particular to emerging markets. I think that as I outlined in the white paper, the two biggest reasons for this are as follows. Number one, if you go way back to the philosophies of guys like Warren Buffet and Peter Lynch, their concept is to buy what you know. If you don’t understand it, then don’t buy it.
In some cases, you know more about certain companies than the analysts do because of your personal experience. I think that it really resonates with people, when you “buy what you know” you feel like you control it. For example, our clients in Mexico love to talk about America Movil (NYSE:AMX), which is Carlos Slim’s company. So even thought that index is already 25-28% America Movil, they still want to buy more; that is one of the stocks they want to talk about. I really feel that it is an issue of control, where people feel better about buying “what they know."
Now, that is just an illusion, in my opinion; just because I buy Apple (NASDAQ:AAPL), and I know a lot about it and its products, that does not mean that I can control how Apple is going to perform.
The second reason falls into the idea of risks. These are sort of back of the prospectus type concepts including currency risk and all of the other risks you would see in the prospectus of a typical emerging market product. For example, you would not want to invest in a country with haphazard taxing across different industries, or one that is fiscally irresponsible, or one where the result of presidential elections is contested, and the results are not known for months … obviously, these characteristics do not describe a third world country, but rather our own.
I think that people do not fully understand risks abroad simply because they are not there physically in the market. For whatever reason, investors seem to feel that it is so much more risky to invest offshore than it is to invest in their home country, because they do not have to deal with those other risks. We are trying to fight these issues as best we can, but let me point out that this issue is not unique to the U.S., but rather it exists all over the world, with some countries holding over 70% of their assets in domestic stocks, though they may only account for a small fraction of the global index.
ETFdb: Which countries/sectors offer investors the most uncorrelated returns?
DG: As you know, our research indicates that as you are trying to explain variability of returns, country effects generally dominate sector effects. That tends to be more true in emerging markets than developed markets. For example sector effects will dominate country effects in certain time frames in developed markets, but in emerging markets it has never been that way. So you have to think about countries that are perhaps a little more isolated form an economic standpoint.
For example, a lot of people say that the euro zone is just one big bloc of countries, so the prospects of the euro zone are the same across the board. I would argue strongly that the prospects for Germany and the prospects for countries like Greece or Italy are entirely different. We tend to think about it more on an individual basis. The way we think about it is to try and find which countries on an individual basis are showing strength in terms of their fundamentals and momentum, countries that are cheaper, or nations that have lower risk profiles than other countries.
If you think about other ways of generating diversification, there are sector over and under weights in particular countries. For example, Peru is 45% materials, Australia is 30-40% financials. So we get to a diversified sector portfolio from the top down. There are a lot of people that would argue to just look at the sector to get diversification. While we believe that to be true, we also feel that you can get more diversification by looking at individual countries and seeing how they have synchronized in terms of policy, earnings growth, ROE, and other indicators along those lines.
Another good option is to look at countries that simply exhibit different characteristics. Let me give you an example, Spain is the cheapest country that we follow, it is also the second most risky, the worst in terms of momentum, and the second worst in terms of fundamentals. So if you were buying the cheapest country, you would buy Spain. The U.S. is a bit more expensive than the average country, but it is much lower risk, with quite strong momentum, which is surprising. All countries have different characteristics to them, and we believe that a portfolio of different countries that have different characteristics will generate the desired diversification.
ETFdb: Do single country small-cap ETFs potentially offer investors a truer picture of investing in a given nation?
DG: Small-cap country ETFs generally have a much different sector profile than the mega cap ones. Some people think that it is more real exposure to the economy, but I would definitely put the world real in quotes. It’s no more real, it is just different. The companies that are in that bottom 15% of market cap are generally exposed to different competitive factors than large caps. It is true that very large multinational companies are subject to different competitive pressures, and they might be a little bit more correlated to the global sectors than the average stock in their country.
However, as we mentioned in the white paper, the top 10 stocks in the countries, in 99% of the cases, are more correlated to their home market than they are to any global sector. Even in the case of the mega cap firms, they are still more correlated to the home market. I believe that you get a slightly different profile with small caps. As an example, the small cap indexes on a P/E basis right now, are quite a bit higher than the large caps in certain countries. It simply depends on what market you are in.
ETFdb: Some people say that because small caps tend to get most of their revenue from their home country, that they are a better play on an individual nation’s market. However, your research does not prove that to be true for the most part, correct?
DG: It is true that most of those companies derive their revenues from local markets, but they have different competitive pressures than the large caps do. It is not any more "real" exposure than the large caps are; it is just a different way of getting the exposure to the economy. It can be a better way in certain places or it could be a worse way, it just depends on how somebody wants to look at that opportunity based on the individual country.
Disclosure: No positions at time of writing.
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