T7 Managing an International Asset Portfolio

Question 1

How is the Aus equity mkt compared to the rest of the world?

Answer 1

global equity mkt dominated by US, UK and JP (collective share of 67%) while aus ecomony is relatively small relative to the rest of the world.
(note though investors who don’t invest offshore might have had nationalism and been in favour of dividend imputation /tax advantage associated with franking credits but they are silly for as investing in docmestic equities have them too concentrated in only certain sectors i.e. resources and financials, not so much in IT.)

Question 2

What considerations should be accounted for when allocating to international equity?

Answer 2

weightings in countries/sectors/industries, management styles, currency mgmt, benchmarks/target selection and location of operations (long as the considerations align with the client’s risk and return objectives);

also consider subclasses, specialist pf mgrs, derivatives mkts, currencies, cash

Question 3

What are the main features of international investing?

Answer 3

1. Correlation:
2. Liquidity: can go both ways, at times internationalised aus mkt can actually detract from liquidity esp. when overseas managers allocate away from aus
3. Specialist industries: how certain industries weigh in the underlying economy are not necessarily reflected in how they weigh in the domestic equity mkts e.g. a few years back when aussies had to invest offshores to get exposure to biotech industry as this sector was not found in the aus equities
4. economic cycle differences: other economies have diff fiscal, monetary policies creating opportunities for aussies to exploit short term local stock and bond mkt conditions that differ from aus mkts
5. currency diversification: there is risk AND opportunity for additional Rs depending on how currency exposure is managed (can be fully unhedged, neutral, cross-hedged, and fully hedged back to the base i.e. AUD)).

Question 4

How can international equity mkt be divided into subclasses?

Answer 4

can be segmented by global industry sectors irrespective of which country it is note 11 sectors as per GICS i.e. global industry classification standard;

or by geographic regions e.g. South-East Asia, Eastern Europe;

or by either developed markets or emerging markets

Question 5

What are the main arguments supporting investment into EMs?

Answer 5

1. emerging and pre-emerging economies account for >80% of world’s population (consumers and labour resources), >75% of world’s landmass (natural resources), 40-50% of total world economic output. they have consistently grown faster than developed counterparts over any long time period.
2. economic growth trends [particularly China driving global growth post GFC] and demographics (vs ageing populations in the developed countries, rising wealth of the middle class, massive migration from rural to cities/urban areas, younger populations and much more intra-regional trade b/w asian countries.
3. as a whole a very diversifiying asset class for its generally low correl to the developed share mkts.
4. while very vulnerable to external shocks in the short run, the fundamentals of the EMs remain very much intact due to national account surpluses (net creditors vs developed nations being net debtors), coys generally holding little debt, consumers generally not highly indebted.
5. important to understand the EMs eventually emerge! 100 yrs ago US was an EM, and so was JP 50 yrs ago.

Question 6

What are the 2 main things to watch out for when investing in international assets?

Answer 6

1. Behaviour of assets - important to note that expected risk-return characteristics only hold over very long periods of time. for any given time period, the idiosynchratic factors peculiar to that period come into effect such that the expected risk-return characteristics may not hold e.g. FI performed unusually well given its risk profile due to the unique nature of a period where interest rates were in strong decline. but this FI outperformance cannot be expected for another time period.
2. Transaction costs - in practice (esp. if active management applies resulting in actively deviating from the benchmark hence high pf turnover which may detract from overall performance), investing in another country can incur 80-100 bps each year of the total pf val in transaction costs (e.g. spreads) plus brokerage plus tax (e.g. stamp duty). 2 common solutions to this problem: 1. use long term investment orientation so as to reduce pf turnover rate 2. use derivatives (to gain cost-efficient exposure to other countries with relatively small amts of capital as lower cost than physcially buying/selling the securities, also good for hedging pf positions by transferring risk to those who are more willing to take on the risk ) altho derivatives can have adverse TE implications too.

Question 7

What is the difference b/w active and passive mgmt in the context of an international equity pf?

Answer 7

active managers aim to add value by outperforming index whereas passive managers maintain that it is difficult to consistently outperform the index over long periods so they aim to match benchmark performance.

• active: typically use msci world index as a benchmark for measuring international shares performance ; uses the process of ‘controlled deviation’ which entails varying % allocated to countries, industries/sectors within countries, specific securities within sectors; need to maintain high awareness about transaction costs incurred by active deviation which may detract from overall return/performance
• passive: to match an index as closely as possible, often as a response to client’s needs; when index changes, not every listed security in the index is purchased tho, just a representative sample that closely follows the index so will slightly deviate from the index and the average variation of performance over/under the index is temred TE i.e. a measure of risk .

Question 8

What are the main approaches to constructing an international equity pf?

Answer 8

1. geographic mix -
   
   • top down manager makes a conscious decision on country allocation THEN specific allocation decisions to stocks
   • bottom up manager select individual stocks THEN country allocation is a mere consequence of the stocks selected.
   • however, as per MPT we know 80% of the pf R variability is accounted for by AA decisions, hence country and currency decisions (as opposed to stock selection) should be the most important decisions in an international pf. To determine AA for an international pf, considerations should be given to {valuation criteria, R volatility, correl of country Rs, economic conditions, imposed constraints}
2. industry mix -
   
   • ​growing use global industry selection and issues associated with that use (focus shift from country selection)- this is because sector effect (% of total Rs explained by sectors) increased while country effect steadily declined since early 90s (except for one short period) hence sector effect surpassed country effect in importance now.
     * *​**

note that investor’s goals and objectives, manager’s style, and type of fund will influence the process of contructing an international equity pf too.

Question 9

Although models and inputs vary across managers and even for a single manager, what valuation criteria is commonly used?

Answer 9

• Divs - dividend discount models and their many variations
• Earnings - EPS
• Price - PE ratio, both historic and prospective
• Gearing - Debt-to-equity ratio, interest covered
• Asset backing - net tangible assets per share

other ratios for assessing relative value: P/BV(price to book value), P/GCF (price to gross cash flow), P/CE (price to cash earnings). Note: for PE ratio, treatment of capital deprec, goodwill varies across countries, so important to use P/**EBITDA** (we are not gonna consider Deprec and Amort) to make PEs comparable between countries.

Question 10

What is the correlation of country Rs like in general? What should an international pf mgr be cognizant of regarding correlation b/w country Rs?

Answer 10

important for the potential risk reduction from investing in countries with low correl (e.g. correl(aus, international equities) been hovering around +0.4).

manager must consider/monitor size, volatility spread, and evidence that a country’s correl has increased recently (mkts generally succumb to increasing global synchronisation i.e. increasing globalisation. think of aus stocks that are listed and traded in NYSE that sort of thing increases correl, and mkts are dynamic and change as economic/structural conditions fluctuate hence historic correl not reliable) to derive real risk reduction from correl.

Question 11

Describe the sorts of economic conditions a manager should research when managing an international pf?

Answer 11

macro issues like the current/future monetary, fiscal policies, growth prospects, political situation should all be assessed as they can have critical impact on not just the country Rs but also other economies.

Question 12

What are ‘imposed constraints’ in the context of an international pf?

Answer 12

imposed constraints are often expressed relative to the index e.g. min/max country or sector exposure, avoidance of investing in EMs or certain industries, max TE constraint, min/max security weights
* constraints may be by client request or manager’s overlay on pf construction
* WHY IMPOSE CONSTRAINTS? constraints ensure true diversification (by country, sector or security) is maintained and pf risk is known and managed. risk-return tradeoff is balanced by controlling pf divergence from the world mkt (Equity - MSCI index, FI - citigroup world gov bond index)

Question 13

What practical problems are there with global industry selection when constructing an international asset pf?

Answer 13

growing use of global indsutry selection (focus shift from country effect to sector effect will likely continue) faces practical problems:

• no global sector derivatives for hedging positions;
• most investment teams are located along geographic lines so moving to a sectoral focus requires a centralised location that is costly to implement and moves analysts away from (time zone and location) convenience re: coys they cover

* note however there is been an interesting trend where **explanatory power of stock-specific factors ( i.e. bottom up stock selection factors** ) increased since early 90s (vs non-stock specific factors explanatory power declined) from 66% to 80% for EW (equal weighted pfs) which may slow down the focus shift to global sector selection

Question 14

international pf mgmt strategy wise, what factors should be considered?

Answer 14

comes down to the question how much to alloate to international assets relative to other asset classes already in the pf, and within the international asset portion what should be the split b/w equities and bonds, and what is the desired level of currency exposure.

• typically, there is a desirable trade-offs b/w E(R) and risks, amongst various mixes of domestic and international equities.
• allowable ranges should be a func of fund’s underlying liabs, tax considerations and subjective factors such as the client’s risk tolerance.
• location of the international asset management team - where should it be? consider position b/w major time zones enabling capture of investment opportunities, office (management) infrastructure, modern technologay ensuring instantaneous communication etc.
• exposure to EMs - decisions subject to FUM size and research skill of the manager (e.g. does he have a dedicated EM team?
• manage resulting currency exposure - research shows active management of currency exposure -> opportunity to enhance Rs.

Question 15

Describe briefly 3 ways of managing EM exposure.

Answer 15

generally there are 3 main approaches for managing EM exposure:
* get a specialist EM manager (will need a min of US$50m to justify the effort and cost tho unless it’s a wholesale pooled vehicle);
* within developed mkts’ mandate, allow manager to invest opportunistically in EMs at discretion, against developed mkts benchmark i.e. MSCI world index
* create a composite benchmark (e.g. 90% MSCI world index + 10% MSCI emerging mkts index ) and allow manager to invest around that.

Question 16

What methods can a manager use to manage currency exposure?

Answer 16

1. Fully unhedged/no hedging - leave it all in foreign currencies (regardless of time period observed, history shows us that some combination of aus and international equities with addition of unhdged currency exposure -> less volatile R outcomes.)
2. totally / partially hedge offshore assets into AUD (facilitated by the currency mkt where investors buy/sell currencies to a future date at an agreed price)
   * if fully hedged -> international assets held as an australian dollar denominated asset, hence effectively no diversification benefit (as there is no chance to profit at all from currency movement).
   * given the wild currency fluctuations, international bonds (offering low and stable Rs) are usually fully hedged. hedging decision for international equities depends on mandate/manager’s discretion but it’s rare to fully hedge all international equities
3. manage currency exposure as just another asset class - typical approach used by institutional investors like superfunds
   
   • ​​ you are essentially separating foreign asset investment decisions from currency management decisions
   • you either oursource the active currency management to an external party (typically employ a specialist currency overlay manager who use futures and options to sell and buy various currencies forward) or internal management team.

Question 17

Regardless if active management of currency is external or internal, there must be 3 components. What are the components?

Answer 17

1. beliefs and objectives to be established (focusing on risk reduction benefit? or looking to target a predefined positive return from the active currency management programme?)
2. determine a strategic hedge ratio e.g. 50%hdg/50%uhdg (similar to SAA and also can be reviewed annually)
3. consider implementation options i.e. either appoint a specialist currency manage to implement or manage it directly/internally. key decision here is set constraints on hedging allowed & this has to be proportional to tolerance bands of other asset classes (if completed unconstrainted hedging is allowed, Rs from currency exposure will swamp the Rs of all other asset class decisions )

Question 18

In common practice, what do investors/inv advisors do to manage currency exposure?

Answer 18

• Usually, investors/inv mgrs employ currency broker/specialist currency manager to manage currency exposure using derivatives.
• also note, as currency management is a macro expertise (vs bottom up stock picking) equity managers inhouse may be able to hedge currency but bond managers do a better job as they are more macro focused.
• in practice, you’d typically use fundamental (largely macro-economic factors: current account outlooks, demand differentials b/w major trading partners, interest rate differentials, capital flow data, purchasing power parity levels and competitiveness, relative monetary and fiscal policies, politial situation, and sentiments etc. ) and/or quantitative variables (technical, quantitative factors) to forecast forex rate and then decide the desirable level of currency exposure.
• how much exposure comes down to

1. how the forecast rate compares to the forward rate for that time frame
2. probability forecast is correct (currency hardest to forecast, lowest information ratio)
3. correl(currency or currencies, other asset classes in the pf)
4. risk of an adverse currency movement to the fund
5. beliefs and objectives (if we are looking to target a predefined alpha ? or forming currency strategies with the focus on risk reduction)