Diversify, diversify: Why spreading the risk is key to global investment

While Japan struggled, emerging markets thrived. It may be daunting but having a wide-ranging portfolio can pay dividends.

(Reuters)

Investors have experienced mixed fortunes over the past decade. While those putting their money into the Global Emerging Markets sector have been rewarded with bumper returns, those who gambled on Japan or technology suffered heavy losses.

Along the way we have seen a global financial crisis, an economic meltdown in Greece, a slew of corporate scandals, changes in governments, regulatory overhauls in many markets and property prices soaring and crashing around the world.

All these events illustrate the inherent difficulties of knowing where to invest. Pin all your hopes on one market and you will have to keep everything crossed that it rises substantially, otherwise you'll be left with a substantial debt in your personal wealth.

For example, the average fund in the UK All Companies sector was down 13.41 per cent in the 12 months to 17 July, 2009, while the Asia Pacific ex-Japan sector rose 7.18 per cent over the same period, according to Morningstar. One solution is to be globally diversified across various countries, argues Jane Davies, portfolio manager of HSBC's World Selection funds. Not only will you always have some exposure to the fastest-growing markets, you also limit the downside risk.

"It means your eggs aren't all in one basket," she explains. "The more globally diversified your portfolio, the smoother your investment returns should be over time. Spreading your portfolio across countries means you're spreading your risk."

This is particularly relevant when you consider that the outlooks for different regions vary depending on recent and current economic conditions. If they have gone through a crisis, for example, they may be better placed for the future.

Asia went through its own financial crisis in the late 1990s, while Latin America has experienced a similar scenario, says Frances Hudson, global thematic strategist at Standard Life Investments. "Asia sorted out its balance sheet after going through a crisis and developed markets have to do likewise," she says. "Broadly speaking, the indebted developed countries are in poor shape, while those in the emerging world look in pretty good shape."

This is a point also raised by Paul Boyne, manager of the Invesco Perpetual Global Equity Income fund, who believes there are great opportunities in countries that are exposed to growth trends. "Many of the world's largest 500 companies are now to be found in emerging markets, including South America, EMEA [Europe, the Middle East and Africa], China and India, and the dominance of the Western world is declining as the rest of the world grows in comparison," he says.

Investors should be reassured by the fact that the world has globalised at a rapid rate over the past 60 years, he points out, with trade now standing at US$12 trillion and accounting for 35 per cent of global GDP. "It is providing new markets and new competition, which is having ramifications for investing," Mr Boyne adds. "Investing globally allows you to access opportunities in industries and sectors you cannot gain exposure to locally."

So how do fund managers decide where to place their money? What factors are uppermost in their minds? Do they concentrate on broader economic issues or are they more focused on the prospects for individual companies? James Smith, an investment director of alternative funds at Isis Asset Management, looks for evidence that particular regions or sectors are undervalued, both against their normal valuation levels and the broader investment universe. "We then take a look at their growth prospects and relate that back to the valuations," he explains. "In particular, we like areas that have underperformed over the medium to long term as we hope that a lot of the bad news is already in the price."

For example, last year's rally resulted in a lot of defensive sectors getting left behind as they were seen as boring. "We're near the point where some of these are very attractive even if you can't see a catalyst for outperformance," he argues. "You can almost throw a dart into a list of large-cap pharmaceuticals and find a cheap stock."

Steady dividend growth, strong balance sheets and decent cash flows are among the benefits offered by this sector – despite negatives such as the US healthcare reforms – with GlaxoSmithKline, AstraZeneca and Novartis among his favoured holdings.

Elsewhere, the HSBC World Selection range has been increasing its exposure to Russian equities for a couple of reasons, at the same time as taking profits after a strong rally from the tactical position it held in Turkish equities. "The valuations of Russian companies are attractive compared to other emerging markets, and they also compare favourably with the current oil price, which is an important driver of earnings for some of the largest Russian companies," says Ms Davies. "There is also improving domestic demand and inflation remains contained, which is positive news from a macro-economic perspective."

Various fund managers will have different views on which markets look attractive, so where does that leave the average investor? Is it best for them to go for individual country funds or opt for a global fund and let the manager make the calls?

Unfortunately, there is no easy answer, says Justin Modray, founder of website Candid Money. A single fund can make life simpler for investors, but buying individual portfolios gives them a far wider choice. "If you don't mind deciding on your exposure to different regions, then opting for several regional funds gives you the greatest flexibility as you can tailor weightings to country and company size to your requirements."

Geoff Penrice, a financial adviser with Honister Partners, believes it makes sense to have exposure to developing economies which are in line to grow strongly, such as Brazil, Russia, India and China. However, he warns against individual country funds. "I would tend to consider global funds because the manager can select the areas they feel will be most productive and move accordingly as things change," he explains, highlighting Aberdeen's Emerging Market Fund and JPM's Emerging Market Fund.

"Both funds have consistently beaten their index, delivered good returns and held up well during the recent problems," he adds. "They are also well diversified in terms of countries and sectors, and have given good returns while protecting clients' capital."

Investors should also consider taking diversification further by having a spread of asset types, with alternatives such as private equity, commodities, property and hedge funds alongside traditional equities and bonds, adds Ms Davies. "There is often a lower correlation between equities and these asset classes, which should overall benefit the portfolio's risk characteristics and lead to smoother returns over the market cycle," she says.

Whatever asset classes are eventually chosen, investors will also need to consider currency risk, says Modray, as this may not be in their favour. Relatively solid companies can be rendered unattractive to UK investors based on currency valuations.

"Buying $1,000 of US shares at an exchange rate of £1/$1.5 would cost you £667, but if the rate moves to £1/$1.6 then your shares would only be worth £625 – even if the share price is unchanged," he says. "Most fund managers don't hedge against this so it is important to understand the added risk that currency movements pose."

Japan

Many investors who put their faith in the country a decade ago have come unstuck, but it has been possible to make money. In fact, James Smith at Isis Asset Management wishes he'd had more exposure there. "At the start of the year we went from underweight to neutral. I was kicking myself because we should have been overweight, given it had a great start to the year," he says. "The reason we didn't get in more aggressively was that we were still slightly cautious about the growth outlook."

Europe

It could be a challenging time for Europe with fears over sovereign risk in some countries, but many fund managers are upbeat about their prospects of finding attractive stock opportunities. Sam Morse, of the Fidelity European Fund, is focused on attractively valued companies that can deliver dividend growth even in more muted economic conditions. "Stocks in Europe are lowly valued in absolute terms and cheap compared to other regional markets," he says.

Emerging markets

Not only have many countries in this region come through the credit crisis in decent shape, they also benefit from the long-term drivers of improving infrastructure, increasing consumption and favourable demographics. Nick Price, of the Fidelity EMEA Fund, insists he is finding plenty of opportunities. "There is a growing realisation among investors that the lasting impact of the financial crisis on Western economies will take time to overcome and that debts built up by governments will have a deleterious impact on economic growth."

So what does the future hold?

Regardless of where investors focus their efforts, the fact remains that they need to delve even deeper into companies, sectors and countries these days, according to Frances Hudson at Standard Life.

Factors which may not seem directly relevant – such as rising unemployment in the UK public sector – could have a dramatic impact on sectors as diverse as technology and outsourcing, so thorough analysis is absolutely essential.

"It's challenging in markets and although it's still possible to make profits, you might have to look harder for them," she says. "You probably need to be more of an active investor than a passive investor and not just trying to buy the market."