September 1998 Issue

Looking for opportunity and diversification

The Eight Imperatives of Global Investing

By Thomas S. Hexner

In Brief

Principles for Investing Overseas

The following eight principles can help a high-net-worth individual get as much as possible from investing overseas:

* Diversify between U.S. and foreign markets as well as among foreign markets.
* Adopt a strategy to manage currency exposure.
* Keep most of your money at home.
* Use mutual funds to take advantage of foreign opportunities.
* Think of developed and emerging stocks as different assets.
* Keep in mind that global research teams are best organized by industry.
* Invest globally, not in U.S. companies that have large global operations.
* Do it.

o claim there's anything "imperative" about global investing may be courting an argument at the outset. After all, isn't the U.S. economy the strongest on the planet? Aren't our society and currency so stable as to be the envy of the world? Hasn't the U.S. stock market been unbeatable (at least until very recently)? Between January 1995 and midyear 1998, the Standard & Poor's 500-stock index was up a cumulative 166%. The major foreign markets in Europe, Australia, and the Far East gained 54% over the same 3 ½ years: a strong return, but not compared with ours at home. If you invested in the smaller, emerging markets you actually lost money over this period, with every $100 invested going down to $72.

But let's rewind the tape 10 years. U.S. stock returns were also very nice during the 3 ½ years between 1985 and mid-1988. But the total market gain of 86% was a far cry from the eye-popping 251% in the major foreign markets. The conventional wisdom was that American industry could no longer hold its own against foreign competition--a notion that sounds, well, quaint today. In four of the next five years, the U.S. and major foreign-market group both took a back seat to the emerging world. The fact is that leadership passes back and forth among stock markets across the globe, and it's hard to predict where the best returns will come from in the next few years (Exhibit 1).

Indeed, we do consider foreign stock investment critical to the building and protecting of long-term capital, and for two reasons. First is the safety factor. Clearly, you can get hurt badly if you've put too much money in the wrong place at the wrong time. The second motivation is opportunity: Without venturing outside the U.S. market, you ignore more than half the value of all the stock in the world, which almost certainly includes some of the best investments at any given time. But, even if you agree that global investing makes sense, there are serious pitfalls to success in this endeavor. Our research and experience suggest that abiding by the following eight principles can help you get as much as possible from investment forays outside U.S. borders.

Diversify, Diversify

As our 10-year comparison of the global markets indicates, the old chestnut about eggs and baskets is as true as ever. And on a national level, the stories are even more compelling. For example, in 1989 the stock market in Turkey gained 547% in dollars. But absent prescience, would you have been in Turkish stocks at all in 1989, seeing as how they had lost 59% the year before? If you did catch the 1989 run-up, would you have left the market fast enough to avoid losing more than half of the whole thing over the next three years? And would you have been back in 1993 to capitalize on that year's 220% surge? This example is extreme, but all stock markets fluctuate, and the best way to avoid getting whipsawed is to systematically spread your risk. The world may be interconnected, but its national stock markets still respond primarily to local interest rates and the local economy.

The fact that when one market is falling another will be rising, and a third will be falling less far, suggests three courses of action. All of them flow from the first global imperative--to systematically diversify.

Diversify between U.S. and foreign markets. On a scale where 0 denotes a random relationship and 1.0 perfect synchrony, the correlation of the S&P 500 with major foreign markets as a group has historically hovered around 0.5: more than low enough to provide a diversification benefit (we think of 0.7 as the threshold). The correlation of the U.S. with emerging markets has been lower still, at about 0.4. Diversify globally, and while in any given year you'll never match the best-performer, you'll always mute the damage from the worst. More importantly, the smoother ride will be more palatable and a positive influence on performance over time, since volatility drags down compound returns. (For example, if you're down 25% in one year, it takes a 33% gain in the next to make up for it.)

Diversify among foreign markets. The same relationship between imperfect correlations and performance holds within foreign markets. The fewer countries you're in, the more you're in thrall to unpredictable vicissitudes. If you were lucky enough to invest in the three best performers in EAFE last year (and hedged all your currency risk), you would have come away with 57%; if you picked the worst three, you would have lost 30%. Facts like these provide perspective on why indexes like EAFE, combining the good with the bad, are usually far less volatile than their constituent country markets and yet typically capture much of the long-term return from the stellar performers.

Don't back off from diversification in times of crisis. Ironically, diversification often has its most salutary effect just when it looks like it's failing: when one plunging market ignites a global chain reaction. The media inevitably play up the story, but frightening as it is, these effects typically last only briefly--for a quarter or so. Afterward, the markets tend to move out of sync again--if not in direction, then in magnitude. For example, over the course of the seven U.S. bear markets since 1970, on average EAFE declined 40% less.

Currency Counts; Manage It

Fluctuations in portfolio value stemming from foreign-currency exposure come with the territory when investing abroad. There are two schools of thought on managing currency exposure: don't do it, and do it. We're firmly in the latter camp; in fact, it's our second global imperative.

Not that the laissez-faire people don't have a point. Exhibit 2 charts the value of the dollar against a basket of EAFE currencies as the dollar rose (from autumn 1978 through early 1985), declined (spring 1985 through spring 1995), and began rising again. As can be seen, when the dollar turned around in 1995, it was close to the level it had started at almost two decades earlier--which is the major argument advanced for eschewing currency management: that currency effects tend to even out over full dollar cycles. And indeed they do.

The problem is that full dollar cycles, clearly, can take a long time to play out. And over the 17 years the last one took, investors had to absorb some painful body blows if they kept themselves totally open to currency swings. In the strong-dollar phase, the depreciation of foreign currencies subtracted 11% a year, on average, from foreign-stock returns for American investors. (It looks as though the new cycle is starting out the same way.) Most private investors don't want to be buffeted like this by currency year-in, year-out; they want the lion's share of their returns from the stocks.

But we've found that there is a way to benefit from currency movements while limiting the volatility:

* Adopt a long-term strategy midway between staying unhedged (owning all stocks in local currency) and fully hedged (converting everything into dollars). With a half-hedged portfolio, you'll likely pick up much (though not every bit) of the currency gains available at any given time without going on a roller-coaster ride and periodically forfeiting most, or all, of your stock returns to currency declines. The principle at work is the same as in country diversification: Maximize the risk/reward tradeoff--not every bet that could conceivably pay off.

* Then adjust exposures, country by country, up and down around the half-hedged average as specific currencies become cheap or expensive. In making those decisions, we look at the factors proven to move a currency: country interest rates and trade balances, momentum (a currency tends to move the same way for a while), and purchasing-power disparities versus other currencies (you should be able to buy the same product or service in any country for the same amount of money, though the equilibration process can take a long time and there are no guarantees). Interestingly, there's virtually no correlation between a country's currency and stock-market performance; so expectations about market performance will probably mean little for exchange rates. (Currency may, however, matter a lot for an individual stock, if the company's profits depend heavily on imports or exports.)

How much will all this change if the Euro comes on the scene next year, as we expect? Clearly, there will be fewer currencies to track. But we don't anticipate the Euro affecting our cardinal rules of currency, particularly that keeping yourself completely exposed to currency volatility can be perilous for your financial health.

Keep Most of Your Money at Home

Despite everything we've said so far, the foreign markets by themselves--and even as a group--have fluctuated more than U.S. stocks. This extra volatility has been particularly pronounced in the emerging markets, but it's also been a factor in the industrialized world. Domestic and foreign stocks need to be mixed in careful proportions, so that the steadying effect of diversification overwhelms the greater volatility of the markets abroad. No one-size portfolio construction fits all, but our research has shown that volatility is minimized over time when foreign stocks constitute some 20­30% of a portfolio. For most private investors, a stock mix roughly 70-80% in the U.S., 15-25% in the developed foreign markets, and five percent in the emerging world is in the right range.

There's an even more important reason to emphasize your home market in investing: You live here. All your liabilities, or surely most of them, are denominated in dollars. You know far more about American companies and corporate culture than about businesses elsewhere in the world. These things count too.

Funds Abroad, Separate Accounts Here

There's also an important difference between the best way to access U.S. stocks on the one hand and the overseas markets on the other.

Here at home, the expenses associated with investing in a separately managed account usually constitute only a light burden--even for relatively small purchases. Abroad, the situation is otherwise unless the costs are spread over a large account base: the volume of pooled capital that the mutual-fund format offers.

Perhaps the best example is custodial costs--generally rather trivial for separately managed U.S.-stock accounts. Overseas, however, because of the multiplicity of countries and currencies, and the fixed minimums typically levied, custodial expenses begin to balloon in accounts below about the $5 million level. With accounts of say, $100,000­200,000 (a typical foreign-stock allocation for high-net-worth investors), most banks wouldn't accept custody at all; if they did, the cost would be exorbitant--perhaps in the range of 300 basis points of assets. In addition, trading in small lots, rarely a problem here at home, tends to be more disadvantageous abroad, since it's not uncommon for share prices to be set at higher levels in other countries, making odd-lot purchases more cumbersome for smaller accounts.

Hence, while the individuation that separate-account management allows is more appropriate for investing at home, mutual funds' huge capital resources are perfectly suited for private investors taking advantage of foreign opportunities. One thing most funds don't do, however, is pay much attention to taxes. And so we are currently researching how a tax-sensitive international fund might be structured, to give private investors the benefit of tax-saving techniques like deferring gains and harvesting losses.

Think of Developed and Emerging Stocks as Different Assets

While stocks are the high-return-potential asset anywhere in the world, this generalization clouds the fact that there are fundamental differences between industrialized and developing countries. Exhibit 3 summarizes how these differences manifest in their stocks and investment climates.

First off, emerging countries have been faster growers; annual GDP growth rates in the range of six percent above inflation--more than twice the average for the developed world--have been the norm. As the economies have grown, so has the people's appetite for life's luxuries--televisions, cars, appliances, telephones--engendering high investment potential in a variety of industries. We're not counting on super-strong economic growth to continue indefinitely, or for the pent-up consumer demand to translate into better long-term stock performance; volatility will cut into returns too much. But even at this writing, when volatility is showing its ugliest face, we don't think investors should ignore countries that represent almost a quarter of the world's productive output.

Still, the rules are different for emerging markets. Even though we consider for our own portfolio only countries where market procedures and investor safeguards are established and reliable, the reality is that emerging markets are by their nature risky and volatile. Given the current situation in Asia, it's doubtful investors need any reminder of that fact. But we'd still mention that over roughly the last decade there was about a four percent chance that in any given month an EAFE stock market would move up or down by at least 10%; among emerging nations, the probability was in the same range that a market would rise or fall by at least 25%. And so while big bets on the fortunes of a specific country are risky anywhere, in the emerging world they're especially so. Transaction costs are also much higher than in developed markets, and currency hedging is either unavailable or prohibitively expensive.

Yet, assembled cautiously as part of an overall investment plan, emerging markets have an important role to play. They give investors access to what have been the fastest-growing countries in the world. They diversify the character of an equity portfolio. And we expect to see streaks again like the late '80s and early '90s, when the emerging world was the best place to be. But we do believe that their characteristics suggest they be managed independently of each other. While emerging- and developed-world stocks can be (and often are) mixed in the same fund, we believe in keeping them in different portfolios to give our clients the flexibility of investing in either or both.

Global Research Teams Should Be Organized by Industry

In a world where geographic borders are becoming increasingly artificial, the profit dynamics behind a company in Germany are essentially the same as a company in the same industry in Italy--or Mexico. For certain industries, like automobiles, oil, and commodities, most people these days accept internationalization as a given. But even in industries often thought of as more local--retail, for example, or utilities--the global similarities are much stronger than the differences. This is not to say that the same industry will be cheap or expensive all over the world at the same time; quite the contrary. Nor is it to say that geographical differences are trivial. Each country has its own investment conventions and cultural customs, which it is the business of the analyst to absorb. But in our view, the components of company profitability are determined, and best parsed, in a global context.

U.S. Multinationals Won't "Globalize"

The seventh imperative responds to a much-asked question: Why invest abroad when so many American companies do booming business abroad? Won't their foreign operations diversify a U.S.-stock portfolio--especially when, as we've just said, business is becoming truly global? It may at first seem as though this strategy makes good sense, but it is not the way things work. While companies in the same industry do tend to have the same basic needs and face the same challenges worldwide, their day-by-day, year-by-year stock performance tracks the market in which they trade. Coca-Cola, for example, may have a ubiquitous presence abroad, but it's rightfully priced, both here and overseas, for what it is--an American company.

And so even when we looked at representative S&P 500 companies that derive more than 60% of their revenues from abroad, we found their performance over the 14 rQ years ending in March 1998 had a high 0.87 correlation with the S&P 500 and a low 0.47 with EAFE. In other words, if you want "foreign-stock-like" performance, you need to invest in foreign-based companies. The American companies we looked at were well-known, established names, in some cases potentially fine investments--for a domestic portfolio.

Do It

Exhibit 4 illustrates why we press our point, via a traditional risk/reward grid covering the period between 1978 and the first half of 1998; it's the empirical evidence on our imperatives. The higher up on the vertical axis, the higher the compound return; the further to the right on the horizontal axis, the more volatile the investment. For the 20 ½ years as a whole, a global mix constructed along the lines we recommend--70% in U.S. stocks and 30% in foreign stocks (in this instance, EAFE performance was calculated with currency positions half-hedged to reflect our long-term recommendations), including a five percent commitment to emerging markets from 1985 on--returned more than the developed foreign markets and the emerging markets and was right in line with the booming S&P 500. The global portfolio achieved this return with less risk than any of its components--much less, in the case of emerging stocks. A money manager employing active rather than index strategies should be able to achieve even better results. In investing, there are no panaceas, only tradeoffs. But that's exactly where global portfolios have shined. In the capital markets, that's as good as it gets, and we expect more of the same in the future *

Thomas S. Hexner is senior managing director for the private-client business of Sanford C. Bernstein & Co., Inc., which managed some $80 billion of client investment assets as of midyear 1998.

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