Global Investing Considerations For Institutional Investors
When I travel outside the United States, I like to buy something that I can use when I get home to remind me of what was hopefully a nice trip. A souvenir like handcream or soap lasts longer than a postcard. Unfortunately, as the world gets smaller and goods are more broadly distributed, it is becoming harder to find an item that can only be purchased offshore. Indeed, on a recent trip to Paris, I could not find a unique item. So much of what I found on the shelves in Parisian stores is already available to me stateside.
This got me to thinking about the dilemma that institutional investors like pensions, endowments, foundations, family offices and sovereign wealth funds now face when seeking to allocate monies to international markets.
As the global marketplace gets smaller, it becomes harder to be a successful active investor. The notion that a change in one country or region quickly impacts others elsewhere - sometimes referred to as the butterfly effect from chaos theory - is real and pervasive. As a result, the ability to diversify a portfolio by crossing borders becomes more difficult, especially without boots on the ground to assist with service provider due diligence and tracking local customs and regulations. When pools of capital are similarly impacted by outside events such as a disruption in oil supplies, election results or sovereign default, it is challenging at best for an investor to assemble a collection of securities that offers protection in the form of natural offsets. Said differently, when a portfolio is truly diversified, some components will go up in value while others go down by a similar amount. That leaves the overall value of the portfolio relatively unchanged over time and thereby immune from big swings in the wrong direction.
One way to track the degree to which assets are closely aligned is to assess the pairwise correlation coefficient. When that number is close to +1.00, the implication is that two assets (or indices) should see their returns moving in the same direction. For example, if the correlation coefficient for the S&P 500 and FTSE 100 increases (as it has done), this infers that an investor with money allocated to both indices will find itself with too many eggs in the same basket.
According to "The Most Troublesome Investment Trend of 2011? Why, Correlation, Of Course!" by Scott Barber (Thomson Reuters, January 4, 2012), the correlation levels between the MSCI World Index and several dozen underlying developed country indices "reached a record of 0.86 in early December" 2011. He goes on to say that while diversification potential is waning, incorrect valuations may give smart investors an advantage. That begs the question as to whether markets are globally efficient "enough" to quickly stamp out any blips in pricing versus theoretically correct valuations.
Aside from the price versus value debate (which deserves its own discussion at a later time), the question remains - What can institutional investors do to mitigate risks as relates to global investing? The answer is that there are many things that a pension fund, endowment, foundation, family office or sovereign wealth fund can do to protect its interests.
For starters, an investor can assess its current exposure to various markets outside its home country. If a portfolio already includes exposures to multinational company stocks and bonds and the various issuers of those securities generate revenue and profit from a handful of countries, an institutional investor should be leery of allocating a big chunk of money to those markets and essentially doubling up, especially if it means that they are violating strategic asset allocation targets as a result.
In addition, it is important to understand the extent to which an international fund manager can hedge currencies. If one objective is to realize gains due to the appreciation of a particular currency, investors will not benefit if hedging has locked in a price or price range and a currency strengthens.
Yet another factor to consider is whether the political will exists in troubled areas to impose austerity measures that pave the way for future economic growth. Unless there is a high probability that rule-makers and polciy leaders will take action to discourage onerous debt loads and encourage prosperity, macro and micro performance will suffer. Notably, at a recent financial conference, the head of global fixed income for a major investment bank said that his team is now forced to take political activities into account.
With newly created "opportunity funds" such as those in search of bargains in Europe, a short track record cannot be ignored. While potential upside could be large for investors with a long-term horizon, it is critical to evaluate the acumen of key traders in terms of how they may have dealt with sovereign restructuring issues in the past.
The flattening of international money pools is a good thing for companies that can benefit from lower distribution and production costs. It could likewise be a plus for institutional investors as long as the relevant risks are properly identified, measured and managed.
Grab your passport and go but do so with care!
Note that "global" typically refers to investing in both the United States and elsewhere. In contrast, the term "international" is used to describe investing outside of the United States.