International equities: taking a global view on equities

Markets may be down but, as Damon Taylor reports, there are opportunities emerging for funds prepared to closely examine their options in international equities.

In the past, investment by super funds into international equities has been about two things: returns and diversification.

By investing globally, funds have sought exposure to those industries not available within Australian shores and the returns that those different markets can bring.

And despite continued uncertainty within all equities markets, Stuart James, senior investment specialist, equities, for Aberdeen Asset Management, said there remained a strong case for investment into international shares.

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“There continues to be a strong case for diversification into international equities,” he said. “The problem is that for the last five years, international equities have underperformed.

“But with respect to diversification, the global market currently has some great opportunities.”

James said most of the structural problems financial services executives had witnessed in international equities were in developed markets.

“On the other hand, emerging markets have been much more cyclical,” he said. “And there is definite potential for them to lead the way out of this downturn.

“The challenge is deciding where to go.”

Yet according to Sean Henaghan, director of international and future directions funds for AMP Corporate Superannuation, a continually changing investment landscape has meant that diversification across all equities markets is increasingly hard to find.

“At the moment, if funds are looking for diversification, there are better places to find it than by going into international equities.

“International equities aren’t about diversification anymore, they’re about returns.”

Instead, Henaghan said there was both a risk and return aspect to consider when relating Australian domestic equities to their international counterparts.

“There is a return and tax advantage inherent in investing into Australian equities,” he said. “But in a share market dominated by materials and financials, the risk isn’t diversified.

“In the past, there’s been a tendency to invest within Australia for that return advantage, but I think funds are realising that that may not be the right approach,” Henaghan continued.

“A lack of breadth can be risky and it may see allocations to international equities creep up over time.”

Speaking to the relative performance of international equities with respect to Australian shares, Mark Delaney, chief investment officer for industry fund Australian Super, said there had been little to pick and choose between the two sectors.

“International equities have done better in recent times on the back of the stimulus that’s been injected by various governments,” he said. “In particular, emerging markets have bounced back well, largely due to China’s influence.

“Most super funds will have de-weighted their equities exposure in both the domestic and international markets based on the poor performance of all equities,” Delaney continued. “There certainly hasn’t been much difference over the last 12 months.

“Nonetheless, international equities continue to be a core part of Australian Super’s equities portfolio.”

Yet while global markets may have been hit just as hard as those closer to home, there was a period before this financial crisis when investment consultants were advising gradual shifts towards international equities on the basis of better value.

James said super funds’ global allocations prior to the crisis had generally been around 30 per cent.

“And for most funds, that probably hasn’t changed,” he said. “Most of the new money coming in is sitting in cash, or it’s been placed defensively.

“We’re not seeing a great deal of it flowing into equities.”

Adding weight to James’ theory on funds’ global exposure, Henaghan said AMP Corporate Superannuation hadn’t materially changed its allocation to international equities as a result of the global financial crisis.

“Rather, we’ve increased our allocation to alternatives and emerging markets,” said Henaghan. “We view these as the assets most likely to get a quicker bounce back.

“I’d say that people haven’t materially changed their attitude to equities, but they’re paying a lot more attention to active management.”

For James, most trustees and super fund executives continue to be pretty risk averse.

“But if funds are looking long term, there is definitely value in international equities,” he said. “And it’s also a great time to be contrary.

“At the moment, defensive stocks are very popular and they’re well stacked up,” continued James. “But generally speaking, profits are waning and returns are down.”

Alternatively, James pointed out that many global stocks, particularly in the industrial space, were priced as if the world were about to end.

“They’re good value and represent some great opportunities,” he said. “And ultimately, they should come out of this crisis in a reasonably strong position.

“The problem lies in how long that might take,” added James. “It could be 12 months or it could be two years.

“But it remains a good time for super funds and investors to avoid following the herd.”

Of course, when it comes to investment and generating returns, particularly in times of uncertainty, timing is everything. And right now, that means many funds are assessing the value in global markets and contemplating the right time to make their move.

With respect to timing, Delaney said it was hard to generalise across Australia’s superannuation funds.

“We all look at the investment environment pretty regularly,” he said. “And in our case, Australian Super does market reviews quarterly and formal reviews annually.

“Those funds with equities ratings drifting down below their long-term targets may consider this the right time to be increasing that allocation,” Delaney continued.

“Yet whether Australian equities look more attractive than global or vice versa is not nearly as important as an assessment of equities in total.”

According to Delaney, investment timing comes down to how factors within the environment unfold rather than any particular date or time.

“Very few funds are market timers,” he said. “Instead, they will have a portion of their portfolios set aside for tactical tilting in addition to what forms their long-term strategy.

“They won’t be trying to time markets, they’ll simply be assessing opportunities.”

For his part, James said while timing was everything, current circumstances dictated that now was a very dangerous moment for super funds to be timing their entry in and out of markets.

“We’ve seen markets fall substantially in 2008,” said James. “But we’ve also seen significant rallies in 2009.

“The best thing funds can do is ride this out without trying to time their investment.”

James said while there was the potential for more downside risk, markets were guaranteed to come back at some point.

“If funds are patient, they should come out of this well.”

However, beyond questions of market timing and picking the right international equities opportunities, there remain other reasons for caution when investing offshore.

A lack of transparency and concerns over corporate governance can be reason for hesitation and despite increasing familiarity, James said quality information continued to be a prime consideration.

“Having access to good information is very important in this kind of environment,” he said. “It has to be a prime consideration.

“Only in this kind of environment will we see the ‘warts’ of some of these highly geared companies.”

James added that under current circumstances, it was vital that super funds were intimate with the details of their international equities investments’ corporate governance.

“I’d suggest that funds have managers on the ground for their offshore investments,” he said. “And that means choosing the managers who are able to have that presence and ensure there isn’t any shenanigans taking place.

“Obviously, there is very little you can do about out and out fraud,” James continued. “But funds can do their best to avoid that kind of situation by sticking to companies that they know and managers with a good track record.

“Funds should be looking for the ‘Steady Eddies’ in this sort of environment.”

Agreeing that offshore investment confidence was about picking the right managers, Henaghan said international equities had, for the most part, reached a point where governance was being closely monitored and investment safety relatively assured.

“Saying that is probably fairly accurate,” he said. “But there are still some markets that funds don’t want to be getting into and in a lot of cases, it comes down to a conversation with your custodian.

“Corporate governance is a key area that funds have to consider, but most will use managers who are already of institutional quality,” Henaghan continued. “They understand those issues pretty well and understand their importance.”

Delaney said the cold hard fact was that Australian superannuation funds had to take corporate governance very seriously with respect to global equities and that the global financial crisis had underlined that fact.

“The key challenge for us as an Australian super fund is that we are a very small player in a large global market,” he said. “We have a very limited influence on those markets, so we need to pick our targets carefully.

“Better governance means better investing and it lifts the threshold returns for all equities.”

Looking more specifically at regions of interest for those funds already invested in international equities or considering offshore opportunities, Australia is fortunate in that it does not have to look very far.

The strength of economies in China, India and Japan have been of great interest to super funds for some time and with many predicting that China will provide the lead out of this financial crisis, the region continues to look promising.

For Delaney, the Asia region is likely to see the world’s greatest economic growth for some time into the future.

“Those countries are already the strongest growing regions of the world and I think that’s likely to be the case for the next decade,” he said. “It’s obviously a favourable area for super fund investment.”

“As with any emerging market, those markets are subject to significant volatility,” Delaney continued. “Gearing, committing capital and finding the right vehicles and managers are going to be the ingredients for success.

“But equities investment in that region is likely to be a key part of our portfolio now and into the future.”

According to James, Aberdeen’s overall view is that emerging markets are likely to come out of the global financial crisis in a far better position than more developed international equities.

“Their balance sheets are in a better position and they have much less debt at both a consumer and government level,” he said. “So as things stand, they have a much better opportunity to come out of this crisis well.

“However, in saying that, I think the Chinese story has been slightly overplayed,” added James. “There’s been a lot of stimulus pumped into the Chinese economy and there are fears that their figures don’t work out.”

James pointed out that while there had been significant economic activity in China throughout this year, Chinese exports had fallen in the first quarter of 2009.

“There’s been a lot of economic activity, but exports have been shrinking,” he continued. “Companies have been working hard and producing, but the fear is that those products are being stockpiled instead of being sold.”

Beyond the current financial environment, taking a longer-term viewpoint on international equities and their place within super funds’ portfolios seems problematic.

On the one hand, most Australian super funds are already well invested into global markets and there continue to be offshore opportunities that simply aren’t available locally. Yet at the same time, the tax, and therefore return, advantage that exists for domestic equities is hard to ignore.

James suggested that there would always be a strong preference for local investment.

“And that’s due to the tax advantages, investment psychology and the comfort level that super funds have with investing into what they already know and understand,” said James.

“They’re also investing into what is a relatively stable financial environment, avoiding currency risk and supporting local business.

“Those things are hard to ignore,” he continued. “But Australia is a very small part of the world and there are a lot of other companies out there.”

Yet the expectation, according to Henaghan, is that international equities allocations must inevitably increase.

“Our current split is around 45 per cent international to 55 per cent domestic,” he said. “But I suspect that will ultimately change to a 50/50 split and then in favour of international equities.

“With Australia representing around 10 per cent of all global opportunities, the question is why any super fund would have more of their equities portfolio invested locally,” Henaghan continued.

“There will always be a larger allocation to domestic equities due to the tax and return advantages but ultimately the trend is international.”

Seeing the equities landscape unfold in a similar fashion, James said there was obviously room for both domestic and international equities exposure within superannuation investment.

“But I think we are certain to see international equities exposure creeping up,” he said.

“Emerging markets are becoming more influential and they are already an increasing part of world economic activity, yet they remain a very small portion of current benchmarks.

“So with Asian markets on our doorstep, Australian super funds are set to have significantly more global exposure in the coming years.”

Commenting on whether super funds had seen anything impact share markets enough to alter international equities investment past the short term and into the future, Delaney suggested that funds would be looking at their overall equities allocation rather than how they weighted globally or domestically.

“For all the differences in composition and capitalisation, equities markets around the world have performed pretty consistently,” he said.

“The timing may have been slightly different, but all markets have gone down in the same way.

“They’ve all gone down around 40 per cent,” Delaney continued. “It’s been hard to find an equities market that’s gone up.

“The key decision remains how much equities investment you have rather than what markets you’re in.”

Coming from a similar standpoint, Henaghan said international equities investment was definitely about diversification.

“Australian financial markets are dominated by materials and financials,” he said. “While globally there’s a lot more diversity, it comes down to risk management and management of the opportunities available.”

For James, international equities investment is likely to remain unchanged as a result of the global financial crisis.

“Long term, people need to be careful that they don’t follow benchmarks when they invest international,” he said. “Simply investing into global markets isn’t the solution.

“If there’s been any sort of big change or any sort of lesson learned, it’s that funds investing offshore need to be very selective,” James continued.

“The days of old school vanilla investments to the US and the UK are well and truly over.”