In Defense of International Investing
The following is an excerpt from the Marathon London Global Investment Review volume 15 No. 4 June 30, 2001 (Introduction section).
"All spin and no delivery"?
- British Conservative Party election slogan, June 2001
In this month’s election campaign that led to the second successive defeat for Britain's Conservative Party at the hand of Tony Blair the above criticism failed to stick, despite its manifold justification. Could the same argument be levied against the advocates of international diversification? In our view, the case for investing overseas is as strong as ever, but the benefits available today may be slightly different to those put forward by earlier proponents. Previously, the fact that stock markets in different countries had different rates of annual returns was combined with efficient frontier theory to argue that international diversification across countries would produce equity portfolios which would generate equal or greater returns with less risk than domestic only portfolios, with risk defined as variability of absolute returns. This reliance on statistical theory has led to some disappointments as diversification has worked in a negative sense as well as a positive one. Specifically US investors, based on the 10 year numbers in the table below have found that, far from the intended result, international investments have lowered average returns and, in isolation, have had higher volatility than the single market S&P 500. British investors have fared less poorly, but only because overseas investments have included the rapidly rising US market.
Table 1: International Diversification, a Report Card on the 10 Years to May 31st, 1991-2001
The superficial conclusion that international investment has raised volatility but reduced returns is not the whole story, however. It is the volatility of the combination of returns that is important and this is clearly different to the comparable volatilities considered individually. The table below compares the two domestic indices (S&P 500, FT-SE 100, both expressed in US$) with the world indices, the latter being a proxy for the combination of the domestic and overseas asset classes. Both UK and US investors have seen reduced returns from international divesification, but both groups have at least enjoyed benefits from lower volatility.
Table 2: Domestic vs. Worldwide Returns (10 year CAGR)
| Index |
Return |
Volatility |
| S&P 500 |
14.88% |
13.91% |
| MSCI World |
10.17% |
13.25% |
| FT-SE 100 |
10.74% |
14.92% |
| FTSE World |
9.92% |
13.39% |
A stronger case for international investing, however, can be made based on the concept of arbitrage: a wider set of investment opportunities will allow an investor to generate better returns than a limited set, everything else being equal. The potential to effect an arbitrage by selling investments with lower future returns and buying those with higher future returns will simply be greater the larger the selection of investments from which to choose.
Everything else is rarely equal, of course. It can be argued that certain domestic markets have better opportunities based on superior productivity, a more favourable macro economic environment, national expertise in key industries, or simply a better way of doing business. But these arguments, when followed through, are supportive of international diversification. For no nation has yet proven itself structurally superior in any of these things and such positive characteristics as do apply occur in individual countries at different points in time. More dangerously, we have found that these arguments gain credibility as share prices move higher; they have been most popular and seemed most credible at market peaks as Japan in 1989, SE Asia in 1997, and the U.S Nasdaq in 2000 appear to confirm. Moreover, if any nation did exhibit a proven permanent structural advantage in economic environment or business practices, currency exchange rates would soon correct for this, even if share prices did not.
Nevertheless the question remains why the increased degrees of freedom afforded by the wider opportunity set (i.e. more shares to choose from) should have not led to increased alpha (outperformance) by most international managers? Part of the reason for this derives from the structural features of the firms concerned and flaws in asset allocation. This is because asset allocation has traditionally been handled with a top down perspective drawing on a preferred house view of the economic outlook. Mindful of the adage that all the economists in the world would find it hard to agree on anything the chances of this process producing superior country allocation decisions is correspondingly slim. There is something in an economist's DNA that is fundamentally rear view mirror oriented. If historic stock returns are good they conclude that the outlook must be positive despite the greater logical case for the opposite conclusion! Perhaps a grounding in efficient market theory (whereby every price accurately discounts the future) is responsible for this. Nevertheless asset allocation decisions have traditionally moved money toward countries whose stock markets are high and away from those that are low, despite the payment of management fees to do the opposite. Fixed weight benchmarks are one client response to this problem, but it is an answer that corrects the phenomenon without addressing its causes. A solution would be to use tools that better correspond to the profit cycle at micro level. Allocating funds systematically to countries with low levels of industrial capacity utilisation, for example, might be one factor with greater predictive power than economic punditry.
As all industries become more global the intuitive case for international investment becomes ever stronger. Apart from the larger opportunity set there are some industries represented in international markets but not in domestic ones, as no nation is dominant in all industries. Even within sectors that are available domestically there may be better opportunities in international markets: Porsche, BMW, Toyota, and General Motors are four different kinds of car company, for example, not to mention Astra of Indonesia and Eon of Malaysia! At any given point in time each trades at different valuations and each offers a different set of investment attributes and risks.
Once again the case for an arbitrage methodology is strong, not least because that is how the companies view one another, having to evaluate the merits of internal versus external growth, normally via some sort of buy versus build calculation. Many financial institutions are now organised into industry teams in order to facilitate, at least in theory, the identification of such opportunities. Unfortunately this has led to the problem of all industry participants rising and falling together. Whilst the American Nasdaq may have been at the heart of the recent TMT boom, echoes took place in practically every stock market worldwide. And in firms consisting entirely of industry specialists it still leaves a problem of asset allocation unanswered, as someone has to decide on the weights versus benchmark in individual industries. All that appears to have happened is that problems of geographical asset allocation have been transferred to the sectoral domain.
Of all the reasons for continuing commitment to international investing we find the softer issues still more convincing. For example (using the tenets of behavioural finance) degrees of investor greed and fear may vary by country and industry. Once again the concept of arbitrage is useful in pointing investors toward attractive investment strategies. Pessimism is crucial in creating buying opportunities and optimism in producing selling opportunities. By training themselves to sell optimism and buy pessimism, institutions may construct sounder portfolios. If investor pessimism is combined with insider buying the insight is normally especially powerful. Historically companies in industries as diverse as cement and broadband have been valued at below replacement cost in one region while simultaneously being valued at multiples of replacement cost elsewhere. Although this metric is very broad and only one of many which should be used in valuing potential investments, it has proven to be a reliable indicator and popular with corporate buyers. Up until very recently investor pessimism was most closely associated with the three most significant "factor bets" in the Marathon portfolio, namely mid-capitalisation stocks, old economy companies and Asian equities. At the moment the Marathon global portfolio has a median market capitalisation of US$4.5 bn, versus one of US$19 bn for the average global stock fund in the USA; information technology/communications exposure worldwide of 8% vs. 23% for the index; and exposure to out of favour Asia is 22% versus 13% for the benchmark;
Other significant opportunities in international investing arise because important principles in creating shareholder value are rarely adopted simultaneously on a global scale. Anglo Saxon markets often lead the way in developing and implementing these principles but the opportunity for international investors, having seen how they work in one region, lies in being able to identify and evaluate the leverage to change that results from adoption in other regions. Even a simple technique like share buy backs was, until recently, unheard of in Japan and illegal in some European countries. As this changes and companies in these markets exercise share buy backs where appropriate, returns to shareholders will rise as they have in Anglo-Saxon markets. Sound ideas in one country can be applied in another, often with little portfolio risk. Once again this is an arbitrage albeit one of a temporal sort. The international investor is able to concentrate his investments at the margin in markets with the greatest leverage to (predictable) change.
Note: This research and analysis has been procured by Marathon Asset Management Ltd for its own use and may have already been acted on by Marathon for its own purposes. The information contained in this research has been compiled with considerable care. However, neither Marathon Asset Management Ltd nor its directors or employees make any representation, express or implied, as to its completeness or accuracy. This research document is only sent to people who have expressed an interest in receiving it, does not constitute or form part of any offer to issue or sell securities and in no way constitutes advice. Under no circumstances may this document, or any part thereof, be copied, reproduced or redistributed without the express permission of a director of Marathon Asset Management Ltd. Marathon Asset Management Ltd is regulated by IMRO and registered with the SEC.
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