Despite the domination of Australian equities in portfolios, global opportunities are attractive particularly for a bottom-up benchmark-unaware manager, Simon Blanchflower writes.
Australian investors may be well aware of the basic diversification benefits of global investing relative to domestic investing, but franking credits tend to win the day and keep home country bias firmly entrenched in portfolios.
There is however, more to the story than is usually understood. It’s worth looking deeper into the risks associated with a portfolio dominated by Australian equities, and the benefits a global opportunity set can provide when constructing investment portfolios for your clients.
While past returns shouldn’t be the only consideration when deciding whether to invest in Australian or global equities, some investors may want to know if there has been much of a return difference. Chart 1 compares the return difference between Australian equities, referencing the S&P/ASX 200 Accumulation Index, and global equities (unhedged), referencing MSCI World ex-Australia Total Return Index in Australian dollars. This return data was calculated on a continuously compounding basis over the past 20 years.
As shown in the chart below, over the past 20 years Australian equities have done considerably better than global equities. In fact, they performed over 50 per cent better on a continuously compounded basis, about three per cent greater returns per annum. However, over the past 10 years, there was much less difference. Australian equities returned 4.3 per cent per annum, whereas global equities returned 4.6 per cent per annum.
The China factor
Why is this? During the first 10 years of this returns comparison, which accounts for the entire 20-year outperformance, the Australian economy was heavily influenced by urbanisation in China, which was beneficial for many sectors and companies within the Australian stock market, especially materials. This was a truly golden period for Australia and one that is unlikely to be repeated in the foreseeable future.
Although resource demand from China will continue, it is no longer from a low base and will have considerably less potency than it did in the early part of the 21st century, especially as China continues to transition from an investment-led to a consumer-driven economy.
Investing in global equities does introduce an additional risk which is not applicable when investing purely in Australian equities – and that is currency risk. In the short-term currency risk can materially impact unhedged global equity returns, however in the long-term currency risk can aid diversification and have a lower impact on global equity returns. The Australian dollar (relative to the US dollar) has had a limited impact on return outcomes over the past 20 years, although Chart 1 does show two distinct 10-year cycles.
Two elements that have influenced the Australian dollar over the last 20 years are:
- The balance of trade benefits from inflated resource prices given the demand from China (in the first 10 years or so); and
- Real interest rate differentials, which supported the Australian dollar until mid-2011.
At its peak, the real interest rate differential with the United States was 0.43 per cent per month, but now it has fallen to just 0.07 per cent per month. This declining real interest rate differential and weaker demand for resources was a considerable tail-wind for unhedged global equity returns over the past five years, as the Australian dollar depreciated.
Despite these strong cyclical pressures, the Australian dollar has had a limited impact over the longer term.
Divide the risk and conquer opportunities
The key to managing your investments is to adequately understand the risks you are taking and have deliberate investment strategies that avoid unwanted risks and capture favourable opportunities. The two key sector exposures in Australian equities, materials and banks, are cyclical in nature. This means there are periods of time when it makes sense to hold more or less of them, and that’s where global equities play an important diversification role.
The sector concentration in the Australian market leads to a greater exposure to systematic or market risk, making it harder to express specific risk (i.e. stock-level risk) in investment portfolios. The benefit of specific risk is that it drives diversification and enables investment managers to express conviction at a company level.
Portfolios can be constructed to reflect a combination of ideas that are both specific in nature (and tied to a company’s performance outcomes) and uncorrelated with one another. This approach can lead to greater alpha generation, particularly when market valuations are elevated. In a global context, the ability to use this approach and find attractive, bottom-up, risk-adjusted ideas is significant given the magnitude of company-specific circumstances across multiple sectors and countries around the world.
Although exposure to systematic risk is hard to avoid, investing in a global context instead of a purely domestic one provides both systematic diversification as well as the broadest company-specific opportunity set in the hunt for alpha.
The other element of global investing is, of course, capturing opportunities. This has always been the traditional argument since the Australian market makes up only 2.7 per cent of the global investment universe.
The financial sector – a diversification example
The financial sector in Australia makes up 38.4 per cent of the index (as measured by the S&P/ASX 200 Index), whereas the financial sector globally makes up 21.2 per cent (as measured by MSCI World Index).
However, it is not just the concentration differences that aid diversification, it is also the pure opportunity set at the company-specific level.
Financial companies are somewhat tied to their home macroeconomic circumstances as well as the competitive dynamics at play, and this provides an important backdrop when considering this sector.
These companies have heightened systematic risk, and therefore competitive dynamics need to be relatively favourable and valuations must be supportive to adequately discount the risks. This is particularly so for banks, which make up a disproportionately high contribution to Australia’s financial sector.
Using MSCI World weights, the chart below shows the financial sector weights by different countries/regions, as well as the component sub-industries that make up the country/regional weights.
For example, the financial sector makes up 43 per cent of the Australian country weight in this index and banks make up 34 per cent (or 80 per cent of the financial sector weight). Consider this in the context of Australia’s 2.7 per cent weighting in the MSCI World Index.
Canada is similar in structure to Australia, but once you move into the larger markets the diversification benefits are more obvious.
Given the risks mentioned above, a global opportunity set is attractive, particularly for a bottom-up, benchmark-unaware manager. If certain markets exhibit unfavourable competitive dynamics, such as an irrational oligopoly or local regulatory policies that overly restrict growth opportunities, one can avoid them altogether.
In addition, a global opportunity set allows better diversification across different business models within the financial sector. For example, one can limit balance sheet risk but still maintain a significant financial weighting in a portfolio by investing in cashflow-driven financials like insurance brokers and stock/derivative exchanges.
A broader country opportunity set simply provides the ability to find circumstances where the local market competitive situation might fuel growth drivers unavailable in Australia.
This example demonstrates the concentration risks in Australia as well as the global diversification benefits within the financial sector. Of course, this can be applied to multiple sectors and all countries, thereby enabling a vast opportunity set.
It’s time to revisit the traditional arguments of diversification, go global, release the shackles, and optimise the risk-reward equation in your investment portfolios.
Simon Blanchflower is head of Asia Pacific at Altrinsic Global Advisors.