The traditional approach to investment has been for funds to be allocated along geographic lines. Hi...
The traditional approach to investment has been for funds to be allocated along geographic lines. Historically, the greater the degree of regional diversification, the greater the spread of risk and the higher the opportunity to raise overall portfolio returns. It can be argued, however, that investment based on country by country allocation is outdated in a world that has become increasingly global.
Long-term trends have seen impediments to trade removed by organisations such as GATT (General Agreement on Tariffs and Trade) and its successor the WTO (World Trade Organisation), as well as the regional bodies such as the EU (European Union) and NAFTA (North American Free Trade Area). The result has been that tariffs and import quota restrictions that prevented the free flow of goods and services around the world have fallen dramatically.
At the same time, governments have acted to deregulate national economies. According to OECD, data exports represented 8% of output from the industrialised world in 1960. By 1999 this figure had reached 25%.
These changes have had a large impact on the operation of companies. The ability of goods and services to move freely across international borders enables companies to produce their products where the unit costs are lowest, and ship to wherever demand is greatest. This not only allows greater control over manufacturing, but also of marketing and pricing.
These companies are very different from the protected giants of earlier decades ñ the threat of competitive pressure has forced business to exploit economies of scale and raise productivity to sustain profitability.
The outcome has been to create global industries and increase the interdependence between the economies of the world. It is therefore perhaps not surprising that the correlation in performance between common sectors within the different geographic sectors of the world has risen significantly over the past decade.
A number of fund managers have reacted positively to the challenges created by these changes in the world environment. Investment houses have established approaches that rely on identifying economic trends and selecting the investments that fit these themes, regardless of the geographic location of a company's stock market listing.
Stock selection based on geographic limitations constrains a fund manager's ability to invest in the best companies and does not really offer the intended exposure to trends within economies.
An example of this is a company like Sony, domiciled in Japan and yet less than 25% of its revenues are earned within the Japanese borders. Sony's earnings can hardly be considered sensitive to the changes in the local economy. This is demonstrated by the company's ability to increase its earnings over the last decade, while the nation's economy has stagnated. When deciding whether Sony is a stock that should be included in a portfolio, it is arguably more relevant to identify the company's dependence on the global demand for electronic consumer goods and the entertainment content associated with this than merely seeing it as a Japanese organisation.
Even for a widely recognised index such as the FTSE 100, more than 50% of the earnings of the companies listed come from outside the UK. Buying this index does not give one a commensurate exposure to the UK economy.
The blurring of listing location from the creation of trans-national equity markets, such as the numerous proposals to link national exchanges can only accelerate the shift away from traditional geographic investment approaches.
In recent years, the concept of examining investments along thematic lines has led to the launch of a number of theme-based funds. These allow individual investors to decide which sectors of the global economy they wish to invest in, instead of determining the weightings that should be placed in individual countries or regions. For example, technology, financials, and healthcare funds would invest solely in tech, financial or healthcare companies, with the fund manager identifying the best sector opportunities on a global basis.
It goes without saying that investors should be vigilant of the potential dangers of concentrating too much of their portfolio in a small area.
Exposure to a tightly constrained section of the overall market can lead to a high degree of volatility in the value of the invested funds as underlying trends see sectors move in and out of favour. If the risk of large movements in the value of a portfolio is unacceptable to an individual, a means of diversifying holdings must be found. This means either investing in a broad equity fund - in effect giving discretion to the fund manager as to which themes should be invested in - or holding a wider spectrum of thematic funds, reducing the impact of the economic cycle on the portfolio value.
Because a fund manager is not constrained to investing in a particular geographic region, thematic investing allows the best investment opportunities to be exploited within a sector. As part of a properly diversified portfolio, thematic funds can be a useful tool for investors who want to tailor their investment exposure to suit their particular level of risk tolerance, and to have more control over which sectors and industries their portfolio is invested in.
Tim Wilson is chief global strategist at Newton Fund Managers Limited
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