November 5, 2010
THE CASE FOR HOLDING A CORE GLOBAL EQUITY ALLOCATION
The world is getting smaller, and that has implications for investing. Perhaps the leading change is the reduction in the potency of the country and industry factors as drivers of the equity risk premium. These sources of priced risk aren't going away, nor are they irrelevant. But they just don't pack as much punch as they once did.
That's not surprising—analysts have been writing about the trend for decades. As capital flows more easily across borders, political and industry distinctions count for less. That doesn't mean that it's time to abandon industry and country analysis, assuming those are your preferences. Those aspects of investing still matter, and they always will. For investors with the skills and desire to analyze and choose industries and countries, there's still opportunity to earn a higher return (or suffer a bigger loss) than the average investor. But as globalization rolls on and investing becomes more competitive internationally, industry and country factors matter less. In turn, the global equity risk premium's influence is rising.
Recognizing the trend, institutional investors have been increasingly focused on global equity mandates. As a new paper from MSCI Barra reports, there's been a "strong increase in the initial funding of global equity mandates: from a mere 6% in 2000, it has grown to represent 38% of all global and international equity initial funding in 2009." A chart from the paper--"The 'New Classic' Equity Allocation?"--illustrates the change:
There are, of course, additional factors to consider for pricing and selecting equities. Financial economics has made great strides over the years in deciphering Mr. Market's rules for asset pricing. So-called style factors are now widely seen as critical drivers of equity return too. Momentum, volatility, value and size, for instance, are key risk factors that are worthy of consideration for designing and managing equity strategies. Indeed, there's an increasing menu of index funds that target these factors as separate and distinct building blocks for customizing portfolios.
But in a world where capital flows freely, the influence of a global equity premium is stronger. From a U.S. perspective, thinking globally has even greater resonance now that the lion's share of the world's equity capitalization resides in foreign stocks.
As of this past September, U.S. equities represented a bit more than 40% of market capitalization on a global basis, according to Standard & Poor's. That's down from more than 50% at the close of 1999.
In other words, the case for holding a globally diversified core equity position is compelling. Institutional investors certainly think so. As MSCI Barra reports, "our research suggests that global equity mandates, together with dedicated emerging market mandates and small cap mandates, may be emerging as the 'new classic' structure for implementing equity allocation."
How much of your total allocation to equities should reside in a global equity fund? The answer varies, depending on your strategy, risk tolerance, time horizon, etc. If, for instance, you're engaging in a relatively high degree of active management, it's reasonable to put a lesser chunk of assets in a core global equity fund. On the other hand, if you have a long time horizon and shun market timing, a higher allocation to a global equity position may be reasonable.
In any case, a global equity mandate should almost always total less than 100% of the portfolio's allocation to stocks, perhaps a lot less. Why? Because if your entire equity position resides in one fund, you're effectively forgoing the rebalancing bonus. By implementing an equity allocation with multiple funds, you can exploit price volatility with a relatively simple strategy of rebalancing--maintaining the strategic equity mix over the long haul by opportunistically cutting back on the winning stocks and buying more of the relative losers. This is complicated and risky with individual securities, but is prudent when implemented using broad definitions of equities. In addition, rebalancing is an easy, forecast-free way of modestly boosting return, or so history suggests. There are other strategic and tactical applications to consider, of course, but rebalancing is a good start for almost every investor.
Holding some amount of your equity allocation in multiple funds also opens the door for tapping tax-loss-harvesting benefits, which can enhance after-tax performance.
Considering these opportunities, a possible equity mix might be constructed with a 50% weight in a global equity fund with the remaining 50% allocated in regional, industry and/or style funds. The latter slice could be rebalanced once or twice a year, while the global equity position constitutes the foundation for capturing the equity risk premium.
The critical variable in all this is finding products that offer all the world's stocks in a low-cost portfolio that efficiently replicates the global equity market. Two strong choices are: Vanguard Total World Stock Index ETF (VT) and iShares MSCI ACWI (ACWI). The Vanguard fund's expense ratio is a low 0.30%; the iShares ETF is slightly higher at 0.35%. Both cover the world, holding U.S. and foreign stocks, in developed and emerging markets, weighted by market cap.
In essence, these funds offer all the world's stocks in a single portfolio at a low cost. As such, they're on the short list as core positions for designing and managing an equity allocation. Institutional investing techniques at institutional pricing are no longer limited to institutions.
Posted by jp at November 5, 2010 6:25 AM
Good point. What I should have wrote is that these are funds that, like most broadly defined index funds, hold a representative share of the stocks with the intent on replicating the target beta. Holding all the world's equities is, of course, technically impossible, primarily because of the smallest stocks, which tend to be illiquid.
Posted by: JP at November 5, 2010 9:29 PM
"...these funds offer all the world's stocks in a single portfolio...."
Not even close to that.
Posted by: walt at November 5, 2010 4:24 PM