investing globally

8/6/2019 Investing Globally

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A global approach to asset allocation requires investors to buy assets denominated in currencies otherthan their home or reference currency. Why would an investor or an investment manager do this?

There are four main drivers behind global asset allocation.

1. Safety of capital

Investing in assets denominated in a 'foreign currency' can offer protection against sovereign andcountry risk factors where the investor's reference currency exposes their wealth to socio-politicalthreats or the capital eroding effects of inflation and/or currency depreciation.

2. Size and sophistication of capital markets

Deep, liquid financial markets with a wide choice of investment products are only available in afew major currencies.

3. Value

In the search for high investment returns ± for undervalued assets with exceptional growth

opportunities - some countries will have better economic prospects than others.

The danger here is that fluctuations in rates between a reference and an investment currency canwipe out any returns which may have accrued in local market terms, turning a winning localinvestment into a losing global play.

4. Diversification benefits

Low correlation between the economic fortunes of different countries offer enhanced investment riskreduction benefits.

The 'safety' of asset markets can be threatened by both socio-political (sovereign and country) risksand inflation (erosion of purchasing power).

Sovereign and country risk

Sovereign risk relates to the reliability and stability of a country's political and legal establishment. Atits most extreme, it involves the danger of expropriation of assets (financial and physical) by agovernment, or a government imposing foreign exchange controls to prevent an exodus of capital.

Country risk is about the integrity of a nation¶s institutions. Financial assets need a strong basis incontract law to prevent an issuing party from not honouring its obligations, and to protect the investoragainst any third party interference. The reliability of a country¶s accounting and banking practises isalso an element of country risk.

A slightly more indirect threat to asset values is the risk of socio-political unrest, which, if it does notthreaten the investor¶s ownership of assets, will increase counterparty credit and investment risk byendangering the smooth-running of the economic system.

Inflation risk

Inflation is highly damaging to both equity and bond market returns; as a quick comparison betweenthe real and nominal returns on three asset classes in the US since 1945 makes clear.



Solution

A safety-first philosophy puts assets into the strongest, µhard¶ currencies. A hard currency is one whichhas exhibited a long-term uptrend. This happens when aCentral Bank succeeds in pursuing anti-inflation policies over the long-term, bringing inflation rates below that of competitor countries andexhibiting low, stable interest rates.

The Swiss franc has always been the classic µsafe haven¶ currency ± with a stable political andeconomic system, and full confidence in the strength of legal contracts to protect the investor. Youknow where you are with the Swiss franc. The Deustchmark was, historically, a second-choice home,with a fine economic (anti-inflation) record and stable political system. The eurozone is, as yet, too

undeveloped both economically and politically to provide these features.

The US dollar is not a µhard¶ currency in the strict sense of preserving its purchasing power. Althoughsuccessful across the 1990s in treading the line between inflation and deflation, the USD has exhibitedlong-term downtrends reflecting erratic anti-inflation policies. (The same is true of Pound Sterling -GBP). And because its society is so dynamic it is not a µstable¶ economic zone. It is creative, chaoticand so sometimes destructive. USD denominated assets exhibit significant asset price volatility ± andthis is exacerbated by the fact that huge amounts of the world¶s riskiest assets are priced in USD (e.g.emerging market debt, junk bonds etc...) ± as are the world¶s physical commodities (hard and softcommodities, precious metals, fossil fuels etc«).

In times of global confidence, there is strong demand for USD so the dollar appreciates against itscompetitor currencies; but in times of global anxiety, there is usually a noticable USD depreciation.

The USD is the most significant global investment currency not because it is µhard¶ in anti-inflation/purchasing power terms - but because its strong legal system and dynamic economy haveproduced the greatest variety, depth and sophistication of investment opportunities availableanywhere in the world.

There are a number of µtechnical¶ features of a national market which will make it more or lessattractive to overseas investors. Every currency¶s asset markets compete for global investment capitalby trying to offer as many of the following features as possible.

Size

The larger an asset¶s market in terms of total capitalisation and volumes traded, the greater themarket µdepth¶ - which is manifested in the form of liquidity. Another advantage of having a constantstream of buyers and sellers coming to a market is that prices will always reflect up-to-the-minuteconditions.

Investment choices

There are three broad classes of financial assets ± money market instruments, bonds and equity ± butwithin these categories there can be a phenomenal range, both of product types and issuercharacteristics.



A wide product range can enhance trading opportunities and increase the precision of an individualinvestor¶s risk exposure and desired levels of return. This is more important to securitised debtmarkets (money markets and bonds) as there aren¶t many significant variations on the equity contractstructure. But the existence of liquid futures and options contracts will make a particular equitymarket more attractive to experienced investors because they can use derivatives to enhance returnsand reduce risk.

MONEY MARKETS BOND MARKETS EQUITY MARKETS CASH MARKETS T-bills, CDs, CP,

notes Plain vanilla, zeros,FRNs, convertibles Ordinary,

preference DERIVATIVES STIR futures and

options Warrants,Government bondfutures & options

Warrants, equityindex futures andoptions, individualequity indexfutures and options

Again only the major currencies offer a wide range of product choice.

Choice of issuers

Global investors will be attracted by a wide choice of issuers.

In equity markets, the Anglo-Saxon economies of the US and UK have the widest choice of issuer ±from µblue chip¶ companies through a medium sized market to highly speculative smaller companies -and across all industry sectors. The US obviously dominates in terms of size.

In debt markets the range goes from zero credit risk , low returning government debt through to highyield junk bonds . The Anglo-Saxon financing technique of µsecuritising¶ debt (issuing bonds) ratherthan relying on non-negotiable (untradeable) bank loans again gives them an edge in terms of thediversity of issuer. Theeurozone is witnessing an ever-increasing use of debt financing and theinternational bond market (the eurobond market) offers a large choice of highly creditworthycorporate issuers.

So generally, the most mature, efficient markets have a greater range of risk/return investmentpropositions both for debt and equity.

However, when it comes to new growth, opportunities may be greater in less developed marketswhere leading companies have yet to reach their full potential. In this context, the search for goodvalue and strong growth can take a global investor into currencies other than the USD, EUR, CHF andGBP.

Opportunities for exceptional investment returns from global investment come from two possiblesources:

1. Buying assets at a low price because the local market is µundervalued¶ ± good value in absoluteterms.

2. Buying assets at a low price because the local currency is µundervalued¶± good value in relativeterms.

Either approach will require a lot of detailed analysis: country/currency risk profiling, business riskanalysis, an understanding of local accounting practices and knowledge of local investors' attitudes.

The local market is undervalued - foreign assets are 'good value' in absolute terms.



In a global marketplace it makes sense for investors looking for future star performers to look aroundthe world. And the increasing development of private sector industries in countries which used to havea large amount of state-ownership has further increased the range of potentially profitableinvestments. Looking for value and growth potential means spotting either a world-beating companyin the making or a new national industry sector growing in order to meet rising local demand.

Smaller currencies and emerging markets can offer significant growth and value potential - but at highrisk - and that is not only investment risk, but also risks arising from the absence of many of thedesirable features covered in the previous topic - namely market maturity and depth.

The local currency is undervalued - foreign assets are 'good value' in relative terms.

Here the opportunity for exceptional returns derives from the fact that the investor's referencecurrency is unusually strong against the currency in which the assets are denominated. This meansthat a well timed purchase can acquire a stock which may be fairly priced in the local market but at alow price for the foreign investor, thanks to the strength of the exchange rate.

For this sort of strategy to work the reference currency will need to depreciate against the asset'scurrency in the future. This is a tactical allocation approach whose success relies upon accurateanalysis of exchange rates as well as clear fundamental analysis of the foreign asset in question.

For example, a USD-based investor may decide that the USD is unrealistically strong against the euro.Combine this view with a belief in the fundamental long-term viability of a particular euro-denominated asset, and the result is a clear buy signal because:

1. you expect the value of the asset you have bought to increase in value in absolute terms and...

2. you expect the value of the asset you have bought to increase in value in relative terms; youexpect the euro denominated asset you have bought to be worth more in dollar terms becauseyou expect the euro to appreciate against the dollar.

Another aim of global investment is diversification.

The aim of diversification is to reduce risk without causing a corresponding decline in totalreturns ± increasing the risk/return trade-off. Strictly speaking, it has nothing to do with thepotential for higher returns in absolute terms.

Diversification - whether international or not - involves picking combinations of assets whoseprices behave in different ways. In technical terms this is described as the extent to which twoassets' prices are correlated.

Assets with prices which more often than not move in opposite directions are called µnegativelycorrelated¶. The risk reduction effect of diversification is greatest with this sort of pairingbecause as one price rises another falls.

But some risk-reduction effects are gained at any time that assets don¶t move in the same

direction at the same time.



Widening investor choice to include different country's markets increases the potential forpicking assets whose returns do not move together ± so achieving lower portfolio risk withoutappreciably lower overall potential returns.

Different country's asset values don¶t necessarily move together because different countrieshave different industrial structures, markets, economic prospects (business cycles), socialdynamics and, as a result, different economic fortunes.

However, this isn't always the case and it is obvious that some types of cross-border

diversification will have greater risk reduction benefits than others. For example, a US investorwill find an investment in Canada less useful ( from a diversification viewpoint ) than aninvestment in, say, the eurozone; the reason being that the US and the eurozone show lesscorrelation, in terms of the behaviour of their economies, than the US and Canada.

Having discussed the various advantages of a global investment strategy, we now need toconsider one of the major potential drawbacks, namely, currency risk.An international investor¶s total returns can be significantly affected by the exchange ratebetween their home/reference currency and the currency in which foreign assets they haveinvested in are denominated.Consider an investor working in US dollars (USD) and another working in Swiss francs (CHF).Both buy a share in the same company traded on the Swiss stock exchange at CHF100. (Asinvestment returns in this example will be in CHF, we will express the exchange rate as

CHF/USD i.e. µhow many dollars does a Swiss franc buy¶).

Opening exchangerate Opening stock price

(CHF) Opening stock price(USD)

CHF/USD 0.50 CHF100 USD50 Let's now assume that a year later our stock is trading at CHF120, a 20% return in localcurrency terms. But that won¶t necessarily be the return in USD terms. To see why, let's alsoassume that the exchange rate has fallen to CHF/USD 0.40 ± in other words the Swiss francnow only buys USD 0.4 instead of USD0.5.

Closing exchange rate Closing stock price (CHF) Closing stock price (USD) CHF/USD 0.40 CHF120 USD48.00

So the USD investor¶s return over the year was actually ±4%, compared to the local currencyreturn of +20%. Highly favourable local market returns have been sabotaged by the CHF¶spoor performance against the USD.Of course, FX movement can have a positive effect on foreign currency asset returns too. Ourexample would simply have needed the CHF to have appreciated against the USD ± so theasset would have bought more dollars, increasing real returns in reference (USD) currencyterms.



The currencymovement« In reference currency

terms In investment currencyterms

«increases totalreturns a depreciation an appreciation «decreases totalreturns an appreciation a depreciation

So investments in assets denominated in non-reference currencies create two separateinvestment risk/return elements ± local market value changes and currency market valuechanges.

investing globally

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