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Thursday, May 11, 2006
Challenge the Indexes
When I called on global equity fund managers in Tokyo, Hong Kong and Sydney during the 1980s to pitch American small cap stocks, I was always struck by the leather covered ledgers they would pull out to jot down notes. No doubt the leather ledgers have been replaced by sleek computer notebooks and the time to meet with small cap stock pickers is probably also a thing of the past.
Why? The enormous size of some global equity funds would make even a ten bagger small cap stock hardly worth the trouble. The big global fund managers need big cap liquid stocks and have little choice but to take a top down approach as they attempt to beat their benchmarks.
This presents independent investors with a great opportunity to beat the performance of the big global fund managers. How? By ignoring country index weightings based largely on the size of a country's stock market.
Let's look at how a portfolio manager of a large global equity fund might approach his task of beating a benchmark such as the MSCI All Country World Index or the MSCI Europe, Asia and Far East (EAFE) indexes. The All Country World index weights 49 countries based on the market value of their stock markets. For example, as of 21 April 2006, the index weights Japan at 11 %, the United States at 45.5 %, Australia at 2.3 %, Indonesia at 0.13 %, Singapore at 0.37% and Germany at 3.1%.
The EAFE index contains 21 countries and excludes emerging market countries. 48% of the holdings are accounted by two countries: Japan and the UK. Add in France and Germany and the percentage climbs over 64%. Meanwhile, the allocation to more dynamic countries such as Ireland and Austria is 0.94% and 0.40%, respectively.
Another method fund managers use in allocating assets is to divide the world into groups such as North America, Europe, Asia and emerging markets and then to weight countries within these categories differently than the benchmark. For example, in the MSCI Asia Index, Japan's weighting is a surprising 68.6%, India is 4%, Singapore is 2.3%, while Indonesia is weighted only 0.78%.
To beat these benchmarks, fund managers allocate assets differently but my experience is that many of the larger funds are "index huggers" deviating from the weightings only at the margins.
Once the country allocation targets are established, fund managers evaluate what companies they should invest in or use passive vehicles such as exchange-trade funds which track a country's stock market index.
You can see that the whole business is oriented towards the largest stock markets. But just because the global asset management business is wedded to conventional backward-looking benchmarks doesn't mean that you have to be.
If you want your global portfolio to outperform benchmarks in a big way, I suggest that you unshackle yourself from the country weightings. Look to the future and weight countries based on their growth potential, capital flows, prices and pace of market reforms.
It makes little sense to me to have Japan, UK, France and Germany account for 64% of your investments in global markets so sell your MSCI EAFE index fund or ETF and do some independent thinking.
If your portfolio's goal is long-term appreciation, India, Ireland, Eastern Europe, or Greater China should be larger allocations than the UK or France. The country-specific iShare ETFs are a good tool for this since you can buy into Taiwan (EWT), South Africa (EZA) or Malaysia (EWM) with a click of the mouse.
What about the risk of investing in smaller stock markets? It seems to me that investing in a vehicle tracking the MSCI EAFE index with 48% exposure to Japan and the UK is riskier than investing 10% of your portfolio in each of ten countries such as Canada, Singapore, Australia, Ireland, Switzerland and Hong Kong. If you include emerging market countries, expect your returns to be a bit more volatile but to paraphrase Warren Buffet in one of his annual reports, I would rather have a lumpy 15% than a flat 12%.
So for big gains, keep your eye on the future and ignore the indexes.
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