In keeping with longstanding practices, many plan sponsors continue to maintain 80% or more of their equity allocation in domestic stocks, despite the fact that the geography of the investable landscape has changed. US companies presently account for only about half of the total global market capitalization and a far lower percentage of revenue. A greater global focus is required to truly diversify a portfolio’s exposure and broaden its potential sources of investment returns.
Home Bias vs. The Next Generation of Global Investing
Market participants are often subject to behavioral biases, which may have an impact on portfolio construction. A home bias refers to a predisposition of individuals to make financial investments in their home country rather than in foreign markets. This generally leads investors to favor domestic stocks even in the context of a global portfolio. This behavior is typically driven by investors having a greater feeling of comfort and familiarity with local companies listed in their own country. Often investors feel more in control of their portfolio because they believe that proximity to home provides them with a relative informational advantage.
However, managers that exhibit such a bias may be limiting their investable universe. Approximately 75% of the world’s largest companies today are located outside of the US. As illustrated below, global investment opportunities have increased as additional countries have become part of the investable universe and the percentage market share of larger countries has decreased.
Shift in Global Growth
While global growth will mostly like be lower than it has been in the past, the medium to long term outlook for Gross Domestic Product (GDP) remains positive. The highest GDP growth will continue to come from the emerging and developing markets.
There are two components of the growth rate that are used to forecast a country’s long term economic growth trend, namely changes in employment (which includes population growth and the rate of labor force participation) and changes in productivity (with human capital as the main driver). Most economists predict that population growth over the upcoming decades will be weaker than it has been in the past. Over the past few decades, several countries have benefited from rising populations of working-age people. While many emerging and developing markets will still have strong population growth (with China being a notable exception), developed countries (with the exception of the US) will have contracting working age populations.
Productivity growth, on the other hand, should continue to be strong. While the US and other developed countries will continue to have high levels of human capital, emerging markets led by South Korea and China have experienced the strongest growth of this kind in recent decades.
Although the emerging and developing markets should experience a slowdown in their growth trends, their growth rates are expected to remain both positive and stronger than that of the US. As China, India, Brazil and others mature from rapid investment-intensive growth to a more balanced growth model, their growth rates are estimated to decline from an average of 4.3% per year from 2014-2019 to an average of 3.2% from 2020-2025. By 2025, emerging markets are expected to capture about half of global GDP, with China being the largest economy in the world.
To benefit from the shifting global growth opportunities described, portfolio exposure has to include multiple geographies around the world.
The New Approach to Asset Allocation
With the global economy becoming more integrated from a revenue perspective, asset allocation strategies focused on a global opportunity set to add alpha, are best positioned to take advantage of changing trends.
Although many companies generate their revenues outside of their country of domicile, many investors maintain an asset allocation based on a traditional boundaries approach, which may misrepresent the risks within the overall portfolio. Fundamental research should instead focus on different company metrics including revenue, profits and assets. Questions such as: “Where does a company generate its revenue and profits?” and “What is the geographical breakdown of a company’s assets and activities?” are becoming increasingly important in an evaluation because a large number of companies are global and driven by multiple factors.
It is notable that about half of the revenues of companies in the MSCI All Country World Index are now generated outside of the US and developed Europe. Those revenues are largely generated in emerging markets despite those markets only representing 11% of the world’s investment opportunity based on market cap.
The implication is that with the decreasing importance of sovereign boundaries, global investing has changed over the last decade, leading to increased correlations among stocks. As a result, due diligence in selecting managers that focus on the best in class companies, regardless of where they are headquartered, has become increasingly important.
Opportunities in Global Investing
The most recent financial crisis resulted in global stock market declines that produced increased correlation among different asset classes and countries. However, global investing is not only about diversification. As noted above, with the decreasing importance of historically dominant countries and regions and an interconnected global economy, investors’ focus should be on selecting the managers who are able to identify the best global opportunities.
The prevailing view among managers that PEI has met with is that global investing should include broadly developed markets, some emerging markets, as well as foreign small cap stocks. Furthermore, global investing is not only about equities, but should also include global fixed income, such as emerging market debt and global high yield, as their real yields are currently above those of the Barclay’s U.S. Aggregate Bond Index. Similar to stocks, the composition of the global bond market has shifted and is currently 35% U.S. and 65% rest of the world. Within fixed income, emerging market debt was hit hard during the tapering discussions by rising interest rates. Despite their short term challenges, emerging markets still have significant long term growth potential. Many of these economies have solid debt/GDP ratios and their fiscal deficits are much lower than the levels of developed markets. Investors concerned about higher interest rates in the US, may consider foreign bond hedged strategies to incorporate local emerging market currency instruments, shift duration risk to other countries worldwide, reduce duration below the benchmark and add global inflation-linked bonds.
Traditional equity portfolios are still constructed with a home market bias, with international equities viewed only as a diversifier. As the world becomes more interconnected, diversification benefits diminish, and equities may no longer be clearly classified as purely domestic and international. The investable landscape is evolving and a globally focused portfolio is better positioned to find the best investment ideas, regardless of where a company is headquartered. A truly global portfolio provides not only geographic and currency diversification, but may also help investors capitalize on the stronger GDP growth trends in foreign markets and realize greater income potential.