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 Financial Happenings Blog 
Saturday, October 31 2009

Regular readers of this blog and website will know that we are not big fans of the big financial institutions when it comes to the costs involved with using their services or approaches to investment.  However they do produce some useful advice for consumers which is especially helpful when you don't have to pay anything for it.

Today I have come across some pages on MLC's (owned by the National Australia Bank) website.  The pages look at the following strategies to pay off debt sooner:

- consolidating debts into the lowest cost option (eg credit cards and personal loans consolidated into the homeloan)
- using emergency cash reserves most effectively - most of us want cash stored away for a rainy day.  Using an offset accpount or redraw facility makes good sense for this purpose.
- making the most of your cash flow through increasing the frequency of payments, reducing living expenses, depositing your entire salary into the loan account, using a credit card to pay most of your expenditure but making sure this is paid off in full each month.

For those in this stage of your life it is well worth taking a look at MLC's website for more details - Pay off your home loan sooner

Regards,
Scott Keefer

Posted by: Scott Keefer AT 11:45 pm   |  Permalink   |  Email
Tuesday, October 27 2009

Each day we read, listen to or view commentators who put their spin on the latest happennings on financial markets.  For those who are keenly interested this commentary can be at times informative and at times even quite amusing as commentators try to explain what has happened and what is likely to happen going forward.

Jim Park from Dimensional Fund Advisors has put his own slant on this issue in his latest posting on Dimensional's website.  He reminds us to be careful paying too much attention to the noise being generated by the financial media.

Following is a full copy of Jim's piece:

From Cacophony to Symphony

Sometimes it's hard to make sense of day-to-day noise in stock prices, particularly when news is thin on the ground. But that doesn't stop lots of people from trying to discern predictable patterns in the racket.

Building coherent narratives out of random stock price moves, often under the pressure of constant deadlines is the job of journalists and research analysts. The most successful ones make it all seem perfectly rational and predictable.

This ability to communicate the idea that 'this happened in the market because that happened' is most brilliantly demonstrated when circumstances change two or three times in the space of a day or two.

Let's take a look at a recent example. In the week beginning October 5, the media reported that markets were anxiously awaiting a policy meeting that week of the Reserve Bank of Australia's board.

While there was disagreement about the timing of the move (most thought it would come in November), there was a strong feeling that the RBA was on the brink of raising interest rates, becoming the first 'Group of 20' central bank to do so in the wake of the global financial crisis.

On the Monday ahead of the RBA meeting, the Australian share market fell by 0.6 per cent. One journalist quoted dealers as saying there was a fear that an early rate hike could shake market confidence and curb the recovery.1

Sure enough, newspapers on the morning of the bank's meeting were full of dire warnings of what would happen to asset markets if the Australian central bank broke from the pack and started to withdraw stimulus too early.2

As it turned out, the RBA did raise its cash rate that day, by a quarter of a percentage point to 3.25 per cent, and a month earlier than most expected.

And what did the Australian market do? It closed higher. The benchmark S&P/ASX 200 index ended up 0.4 per cent, albeit off its intraday peak. According to an analyst quoted by Dow Jones, the rate rise could actually be seen as confirmation of the strength and resilience of the Aussie economy.

But the story didn't end there. Not only did the RBA's "surprise" rate move fail to derail the Australian market, it actually triggered a global rally. The Wall Street Journal: "A surprise interest rate increase in Australia reignited confidence that the global economy is recovering from recession, sparking stock market rallies around the world and lifting gold prices to record highs."3

You see how these rolling interpretations work? You keep changing the narrative to suit the changing circumstances. The trick is to make it all seem perfectly obvious after the fact. "This happened because that happened."

The fact is stock prices move for all sorts of reasons, and trying to provide neat and immediate explanations is a treacherous business for young players. Sometimes a price changes because of news related to the individual stock. But even then, just as with economic news, the reaction is not always what the media say it will be, usually because the market has already priced it in and is looking one step ahead.

Back in mid-September, the Australian government created a stir when it announced that it would force the nation's largest phone company, Telstra, to split into separate wholesale and retail businesses.

On the day of the announcement, Telstra shares slid more than 5 per cent. The government's break-up order, according to one wire service report4, represented a "giant kick in the teeth" for the company's shareholders.

The next day, though, the story changed. Telstra shares regained all of their losses. Analysts had now reviewed the break-up plan and decided it would help position Telstra to secure part of a lucrative national broadband deal.5

So the narrative of why stock prices rise and fall on any day changes because new information is always coming into the market. No sooner has the journalist carefully crafted a water-tight story out of one development, than something else happens and the whole edifice springs a leak.

Stocks often move because of investors' views of equities as an asset class, not for any reason related to the individual stock. The market may move higher or lower and individual stocks will shift up and down by a certain amount in sympathy, depending on how sensitive they are to market risk.

Stock prices also can move for apparently no reason at all, or at least for no reason that the media takes notice of. It could be because a large institution is liquidating a portfolio or because of arbitrage activity between the physical and futures market or because of options expiries. It may just be because someone is selling a large parcel of one stock to fund a purchase of something else. None of this is particularly interesting or significant in the big scheme of things. It's like watching rush-hour traffic.

The bad news for harried journalists and market analysts is that they have to try and orchestrate all the random noise that constitutes messy day-to-day reality into a fascinating, elegant and seemingly pre-ordained symphony. And every day, they have to start all over again.

The good news for the rest of us is that there is no compunction to listen.


1'Australian shares fall 0.6%, banks skid on rate talk', Reuters, Oct 5, 2009

2'Housing disaster looms if rates rise', The Australian, Oct 5, 2009

3'Australian rate rise spurs stock, commodity rallies,' The Wall Street Journal, Oct 7, 2009

4'Shareholders say not one good thing in Telstra proposal', Australian Associated Press, Sept 15, 2009

5'Australian shares up 2.4%, banks surge', Reuters, Sept 16, 2009

Posted by: Scott Keefer AT 09:36 pm   |  Permalink   |  Email
Sunday, October 25 2009

The issue that tends to get the most air time and newspaper coverage in highlighting all that is wrong with the financial planning industry is the issue of trailing commissions.  This is the pratise whereby advisrs are paid a fee from product providers for recommending a client invest in that product.  The perceived problem with this is the accusation that can be alleged that a planner is recommending a product based on the amount of commission they are receiving not because it is in the best interests of the client.

I agree that this is a practice that needs to be looked at.  However an even larger issue for me is that of ownership bias.  This is where planners, because they are owned by a large financial services company tend to recommend that company's investment products.  I think the same allegation of whether this recommendation is in the best interest of the client can be levelled at a planner.  At least with trailling commissions, planners can recommend what they think is the best outcome for client.

Of course, combining the two is probably the worst of all outcomes.

An article published in the Herald over the weekend provides some interesting data on this issue - Finance advisers mostly a sales force, report says.

"In the year to June, for example, 80 per cent of sales by financial planners at Westpac and its subsidiary BT went to funds owned by the bank. The in-house sales figure was up from 72 per cent a year earlier.

For financial planners working for money managers AXA and AMP, 82 per cent of their sales return to their parent company. Colonial and the Commonwealth Bank retain about 72 per cent of the sales of their financial advisers.

The study was based on figures from July 2005 to June 2009 from almost 6000 superannuation products obtained from the six leading planning groups."

Now it might well be that the investments offered by these planners are in the best interests of the client.  Unfortunately there is such a level of perceived conflicts of interest for investors that theis assertion would be seriously doubtful.

The research based approach used by A Clear Direction suggests that the type of funds recommended by the big financial institutions tend to be actively managed, higher fee offerings which over time tend to provide below average performance.

In conclusion, take care when using the services of the big financial services industry that the advice being offered is in your interests not in the interests of the controlling company.

Regards,
Scott Keefer

Posted by: AT 08:00 pm   |  Permalink   |  Email
Thursday, October 22 2009

MENSA is the group for individuals with IQ's in the top 2% of the population.  They have an investment club, and Eleanor Laise looked at this investment club in an article entitled ?If we are so Smart, Why Aren't We Aren't Rich?'.  

 

Over the period 1986 to 2001 the Mensa investment club managed a return of 2.5% a year.  The average market return for this period was 15.3% a year. 

 

From the MENSA club chair: "it was my hope that a special-interest group within MENSA would have the intellect that would give us some kind of advantage."

 

What, then, explains the disparity between club members' formidable IQs and derisory results? Laise provides a strong hint: during the past 15 years its chairman-editor has also been "a committed chartist and incorrigible techie [who] has transformed the club, which has $70,000 in assets, from a small-cap, value-oriented group to a highflying, momentum-buying Nasdaq nightmare. The centrepiece of his strategy is the TC 2000, a technical charting program that seems like a prop from the set of Star Trek. [According to the chairman-editor], ?this program is the coolest thing. You can show various types of graphs and add indicators, like linear regression, moving average, Bollinger bands. Then there's volume, stochastics, MACD, time-segmented volume, stuff like that. You can add all kinds of indicators and really confuse yourself.'"

 

It is an interesting story - and interesting to see the ?smartest guys in the room' with the best software support struggling to generate a reasonable rate of return.

As Warren Buffett - one of the world's great investors - has said, "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ..What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from  corroding that framework."

 

(source: sensible stocks . com - original article in Smart Money)
Posted by: AT 05:27 pm   |  Permalink   |  Email
Wednesday, October 21 2009

Scott's latest article in the Eureka Report looks at the prickly issue of executive remuneration packages.  Removing ourselves from the debate around fairness, Scott cuts to the heart of the issue for investors - What is the impact on share price?

In his article Scott conducts analysis on 3 household company names - Commonwealth Bank. Telstra and Qantas to look at the impact of reducing executive pay levels.  He concludes:

"The calculations for Qantas, Commonwealth Bank and Telstra show that big salary packages to affect earnings and share prices, but not to a great level. Indeed, if a highly skilled executive were able to increase shareholder return by 1% a year, they would justify the paying of a high salary.

The more interesting story is that of the Productivity Commission recommendations and its recommendations to give shareholders more power to vote on executive remuneration, recommendations supported by the shareholders' association.


Moves away from continued salary increases well in excess of inflation, to genuinely involving shareholders (company owners) in the remuneration process, would seem to be a step in a positive direction."

Please click on the following link to be taken to the article - Why executive pay doesn't matter (to shareholders).

Posted by: AT 06:25 pm   |  Permalink   |  Email
Tuesday, October 20 2009

In a recent article published by Scott Francis in Alan Kohler's Eureka Report, Scott looks at the strategies that can be implemented by those close to retirement and suggests some relatively minor changes can lead to a significant improvement in outcomes achieved.

Scott identifies four factors that will reward those who stay or go back to work:

  • The chance to invest while investment markets are depressed.
  • The chance to put in place a (very) tax-effective transition to retirement income strategy.
  • The chance to deliberately use your superannuation contributions to position your retirement portfolio.
  • The fact that the longer you work, the shorter the period that you rely solely on your investment assets to fund your retirement, and the more likely they are to meet your needs

For those of you at that period of your life or who have family or friends who are, I encourage you to read the article - Winning in the retirement risk zone.

Posted by: AT 06:19 pm   |  Permalink   |  Email
Tuesday, October 20 2009

Since the beginning of the new financial year work loads have been strong particularly with the introduction of a number of new clients.

I am starting to get on top of this work load and have caught up posting Scott's 3 latest Eureka Report articles.

The first of these was published back on the 14th of September and looked at the issue of preferential treatment to institutional investors as opposed to retail investors in relation to rights issues implemented by companies.

Scott takes aim at this practice and identifies the best and worst approach that has been adopted - What about me? I want my share.

Posted by: Scott Keefer AT 06:05 pm   |  Permalink   |  Email
Friday, October 16 2009

The following is a great piece of commentary by Weston Wellington from Dimensional in the US.  Please note that the references are to US data but the results have been translated into the Australian context through a recent report prepared by Standard & Poors.

Enjoy the read.

Report Card for Active Managers

Morningstar recently announced the introduction of a new "Box Score" report analyzing the performance of actively managed US equity mutual fund managers. Morningstar's analysis starts with a universe of 22,000 US equity funds and prunes the list by aggregating multiple share classes and eliminating exchange-traded funds, sector funds, bear market funds, long/short funds, and lifecycle funds. They also exclude funds deemed to have a "passive-like" investment approach, specifically citing Dimensional strategies. All funds available for purchase at the beginning of any particular time period under review are included, so the results are free of survivor bias. Morningstar compares results to their own stock indexes, which seek to capture the returns of the nine distinct Morningstar style boxes (large cap growth, mid cap value, etc.), and evaluates performance by calculating both Jensen's alpha and a more comprehensive Fama/French alpha.

The report is similar to the SPIVA report (Standard & Poor's Indices versus Active Funds Scorecard), which compares actively managed funds to various S&P and Barclays indices in US equity, international equity, and fixed income markets. S&P uses the CRSP Survivor-Bias-Free US Mutual Fund Database, and, like the Box Score report, is published semiannually.

Although we found the Morningstar report rather light on documentation, both reports are useful in providing a regularly updated analysis that quantifies the challenge facing investors seeking to identify winning money managers.

A few nuggets from recent reports:

  • Morningstar finds that 41% of actively managed funds outperformed their respective indexes for the three-year period ending June 30, 2009, using a measure of Jensen's alpha. But Morningstar notes that "once the Fama/French factors are taken into account, active managers' outperformance relative to the indexes falls materially." By the latter measure, only 37% of managers outperformed, and average alpha was negative in all nine style categories.
  • S&P reports that only 31% of large cap core funds for the five-year period ending June 30, 2009 outperformed the S&P 500 Index. Results were even less favorable for non-US markets, where 13% of international funds and 10% of emerging markets funds outperformed their respective benchmarks. We often hear that non-US stock markets exhibit greater pricing errors than the US, supposedly offering a target-rich environment for clever stock pickers. The numbers suggest this is wishful thinking.
  • Fixed income markets were no less challenging: for the same five-year period, Standard & Poor's found that 22% of intermediate government funds were outperformers, and the number dropped to 11% for high-yield bond funds and only 2% for mortgage-backed securities funds.
  • The fund attrition rate is significant: S&P reports that 27% of the 2,154 US equity funds in existence five years ago have merged or liquidated as of June 30, 2009. For reasons unclear to us, the number jumps to 39% for large cap blend funds, the worst among all style categories. Morningstar reports that 10% of small growth funds have disappeared in just the first six months of 2009.

Both reports can be downloaded from their respective publishers at no charge:

The Morningstar Box Score Report: Alpha Seekers, Caveat Emptor, First Half 2009.

Standard & Poor's Indices versus Active Funds Scorecard: Midyear 2009.

Posted by: AT 03:29 am   |  Permalink   |  Email
Friday, October 09 2009

Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients.  In response to this feedback we have updated these graphs to reflect performance up to the end of June 2009.

 

Commentary:

 

The graphs show strong monthly returns over the month for the Australian share asset classes with international share investments relatively flat for the month mainly due to the impact of currency movements.

 

Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:

 

Australian Share Trusts - 7 Year returns

 

 

7 Yr Return

to Sept  2009

Premium over ASX 200

Accumulation Index

ASX 200 Accumulation Index

13.46%

-

Dimensional Australian Value Trust

16.17%

2.71%

Dimensional Australian Small Company Trust

16.65%

3.19%

 

International Share Trusts - 7 Year returns

 

 

7 Yr Return

to Sept 2009

Premium over MSCI World (ex Australia) Index

MSCI World (ex Australia) Index

1.96%

-

Dimensional Global Value Trust

4.16%

2.20%

Dimensional Global Small Company Trust

5.14%

3.18%

Dimensional Emerging Markets Trust

15.26%

13.30%

 

NB - These numbers are average annual returns for the 7 year period which are slightly higher than the annualised returns.

 

Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

 

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dfaau.com).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.

 

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Posted by: Scott Keefer AT 10:48 pm   |  Permalink   |  Email
Friday, October 09 2009

I subscribe to reports and analysis produced by McKinsey and Company.  The purpose of which is not to try to picj and time investment decisions but to get an understanding on what is happenning in the global economy for my own personal interest and as a point of discussion with clients.

McKinsey publish a regular report based on results from surveys conducted by company executives.  What stood out in the latest report was a graph looking at the profit expectations, changes in the workforce and expected demand.

The results showed that more company executives thought that company profits would increase going forward, the first time since September 2008.  Expected demand for company priducts was also rising over the past 4 months of surveys (June to September)  and there is now an equal balance between those that expect workforce levels to rise compared to those that think they will fall.

It seems to me that this is further evidence that business sentiment is on the improve worldwide.  Similar conclusions have been coming through business sentiment surveys here in Australia and in the US.

The report concluded with the following points looking forward:

? Most companies are not in crisis: they're managing in a new normal, with an enlarged role for government and lower long-term growth expectations.

? Innovation is more important than ever; the companies that have the highest hopes for their own futures are likeliest to be focusing on it.

? January was the month when executives expressed the direst views about the economy. They now look forward to economic growth, but few expect a quick, full recovery.

The report does nothing to change my view that although things are much improved from the dark days of late 2008 and early 2009, the road back is a long one.

Regards,
Scott Keefer

Posted by: Scott Keefer AT 05:30 pm   |  Permalink   |  Email
Thursday, October 08 2009

My last two blogs, any many before, have made reference to thoughts from Dimensional and Vanguard representatives.  Today, in the interest of balance, I want to provide thoughts from a more active style approach to investing in fixed interest put together by AMP Capital.

The following link is to an article published by Professional Planner which discusses the topic of investing in fixed interest.

Special Report - Fixed Interest

The article is useful because it simply explains the basics when considering fixed interest alternatives, and in particular 2 major risks - credit default & liquidity risks:

"Thee former is the risk that the bond issuer defaults on its repayments; the latter is the risk that you can't buy or sell the volume of bonds you need to, at the price you need to."

A major part of the liquidity risk is the risk that interest rates are higher in the economy than when the initial bond was issued and therefore you are unlikely to be able to "get back" what you paid for the bond should you need the money before the bond matures.

This firm's approach is to be very targeted in what style of fixed interest clients have in their portfolio, in particular focussing on high quality offerings (rated AA or AAA) and keeping time to maturity of the underlying bonds less than 5 years which keeps a lid on liquidity risk including the impact of interest rate rises and inflation increases.

Our objective is for this investment to provide a few percentage points better return than cash over the long term.

How do we do this?

A good investment to consider is Dimensional's Five Year Diversified Fixed interest Trust.

We consider it probably the best put together fund by Dimensional as it strategically targets the sweet spot in the yield curve for fixed interest investments within the 5 years to maturity window.  Returns from this trust continue to show it is meeting its target:

1 month - 1.05%
3 months - 3.31%
6 months - 4.51%
1 year - 8.51%
3 years - 6.78%
5 years - 6.19%

For more information please take a look at the Product Fact Sheet on Dimensional's website.  As always, before investing in any investment it is important to consider your own individual needs and circumstances.

In concluding, as reported in AMP Capital's article, the key with fixed interest is to have broad diversification and be careful with credit and liquidity risk.

Regards,
Scott Keefer

Posted by: Scott Keefer AT 10:33 pm   |  Permalink   |  Email
Wednesday, October 07 2009

Robin Bowerman from Vanguard has written a piece on the Money Blogs for News Ltd considering the topic or market timing.  It is worth a look and due consideration:

Market timing: an investor's game of chance

On the blog he provides a link to Vanguard's updated Index Charts through to the end of June 2009.  This chart provides further support to the argument Bowerman proposes.

Vanguard Index Chart - 2009


The charts provide a great insight into longer term returns for Australian investors in a range of asset classes.  The 31 year returns have been:

Australian Shares - 15%
International Shares - 12.7%
International Shares (hedged) - 10.0%
Australian Bonds - 9.8%
Cash - 9.7%

The premiums from investing in the more volatile growth assets have definitely shortened over the course of the past 12 months but even after one of the worst years of investment performance in these asset classes the benefits are still evident.

We could spend hours contemplating the numbers thrown up the charts but the general reminder to me is the importance of good diversification across all asset classes including cash & fixed interest.

Regards,
Scott

 

Posted by: Scott Keefer AT 09:55 pm   |  Permalink   |  Email
Wednesday, October 07 2009

Indonesia has a special place in my extended family and my life.  i therefore am very interested in the plight of their economy and their share market.  Indonesia is a part of what the investing world will define as Emerging Markets.  The exact description of this term will differ from investment house to house but for economists it is generally speaking the "developing" economies of the world including Asia (ex Japan), South America, Eastern Europe and Africa.

A lot of analysis over the past year has focussed on how these economies have fared better and might be the key to a strong global economy into the future.  No surprises then to see Emerging Market indices rise much stronger and faster compared to the more developed (rich) economies.  Indonesia for instance has risen 123% for the year to date to the end of September as measured by Standard & Poors.  Their Emerging Markets Index has risen 64.5%.  Developed World markets have risen less so - 25.3% according to S&P (All in US dollar terms).

Most investment analysts would suggest their clients have some exposure to Emerging Markets, as does our firm, however the question becomes how to get that exposure?

A recent article written by Dimensional's Jim Parker provides an insight into how Dimensional Fund Advisors see this decision with particular reference to China.  The full text is repeated below:

October 2009
Chinese Walls
 

Investors confronted by the recent less than stellar performance of the US economy, traditionally the world's powerhouse, are being urged to increase their exposure to China and other emerging markets. But how?

A traditional response to that question is that the best way of "buying the China story" is to re-weight one's global portfolio away from the developed economies of North America and Europe to high-growth Asia.

It sounds like a tempting strategy, particularly given the change in focus in global policy-making away from the Group of Eight rich western economies to the Group of 20 that also embraces China and other emerging economies.

Rightly or wrongly, the origins of the global financial crisis in the US and Europe are seen as shifting the balance of world economic power, a tilt that was evident recently as G20 leaders gathered in Pittsburgh.

The so-called 'BRIC' emerging economies ? Brazil, Russia, India and China ? were among those leading calls at the G20 summit for what they perceive as the need for a fairer and more inclusive set of global economic structures.

Partly in response to this apparent rebalancing of economic power, much of the investment industry is aggressively marketing strategies that seek to provide investors with greater exposure to the BRIC powerhouses.

So how should individual investors respond to this pitch?

Firstly, it is certainly true that emerging markets can play an important role in a portfolio. They provide great benefits in terms of diversification and offer higher expected returns than developed markets as compensation for the higher degree of risk of investing in emerging markets.

But investors should also keep in mind that the size of the market opportunity is not necessarily the same as the size of the economic opportunity.

The table below, from the World Bank1, ranks the top 20 countries of the world by gross domestic product and adjusted for purchasing power parities. This is a way of taking account of the relative prices of goods and services in each country and provides a better measure of the real value of output.

As you can see, the BRIC economies are well represented in this list, taking up the second, fourth, sixth and ninth positions on the table. Australia is relatively low in this ranking, in 18th position between Iran and Poland.

Now, take a look at the country weights of the MSCI World All Countries Investable Market index2. This takes into account the actual opportunities in these countries for global investors, after adjusting for local market restrictions on foreign share ownership.

In this list, China is in ninth position with a weighting of just over 2 per cent of global market capitalisation, Brazil is in 11th place, India is in 18th position and Russia is at the bottom of this abbreviated list.

Australia ranks at number six in terms of market capitalisation, just below Canada and ahead of Germany. And the US, as well as the biggest economy, is also the most heavily weighted market, with a country weight of a little more than 40 per cent.

What this tells us is that in developing economies, the real economy tends to mature faster than the financial market that supports it. Weighting an investment strategy around the gross domestic product of each country will tend to result in an overweight towards emerging markets. Of course, this may be a legitimate choice for some people, but bear in mind it would also be a riskier strategy.

The second consideration is that emerging markets should be treated not as an alternative to developed markets but as a distinct asset class. While they offer higher expected returns, they often also tend to be more volatile. These distinct risk-return characteristics mean they require careful management.

As an investment manager, Dimensional considers a number of practical issues when deciding whether to enter a particular emerging market. These include the particular country's respect for property rights; its fair treatment of foreign investors; quantitative measures such as liquidity, market cap and stock concentration; agency risk and trading mechanisms.3

Even when a country meets strict criteria around these specific issues, there are still risks for investors in having too much exposure to a single market. Dimensional deals with this by weighting countries by market cap, but with a buy cap of 12.5 per cent for any one country.

In some cases, when foreign participation in a local equity market is severely restricted, Dimensional will seek exposure to the companies of that market through their listings in more developed markets via depositary receipts and other alternative vehicles. For instance, it accesses the returns of Chinese companies by buying their 'H' shares listed on the Hong Kong market.

Against that background, it seems clear that building an emerging markets strategy around just the BRIC economies means taking on diversifiable risk. Apart from the fact that they are big and they are growing rapidly, these four economies have little in common. Brazil and Russia, for instance, are commodity producers, while India and China are commodity importers.

Another consideration for investors is that getting greater exposure to say the Chinese or Indian growth stories can be achieved in ways other than investing only in Chinese or Indian companies.

BHP Billiton, for instance, is the world's largest mining company and the biggest company on the Australian market. With its voracious appetite for raw commodities, China represented 20 per cent of BHP's global revenues4 in fiscal 2009, with India also an increasingly significant contributor. Obviously, then, owning BHP stock provides indirect exposure to those economies.

BHP's experience is true for the Australian economy more broadly. According to the Reserve Bank of Australia, 23 per cent of Australia's total exports went to China in the June quarter of 2009, up from about 4 per cent a decade ago.5

Australia's close linkages with China, through commodity exports, partly explain its extraordinary resilience throughout the recession that has hit developed economies in the past year. So an Australian investor who bemoans his lack of exposure to China needs to look first in his own backyard. He has a degree of exposure just by investing locally!

And this is not just true for Australia. In the US market, an increasing proportion of the sales of listed American companies are sourced offshore. Indeed, Standard & Poor's estimates6 that of the reporting companies in the S&P 500, just under 48 per cent of all sales last year were produced and sold outside of the US, up from 45.8 per cent in 2007 and 43.6 per cent in 2006.

Among the major US multi-nationals, Alcoa and Motorola earned significant sales in Brazil, while Citigroup and Intel had a big exposure to the Asian economies, according to the S&P data analysis.

This means that investing a significant proportion of one's global assets in the United States equity market does not necessarily equate to taking a taking a similar sized bet on the US economy. The US market plays host both to American multi-national corporations with significant overseas revenues and to leading companies from economies around the world ? both developed and emerging ? that are seeking to tap the most liquid market on the planet.

So in summary, it is true that emerging market economies are representing an increasing share of world economic output and that the investment returns of companies in these markets deserve a place in a diversified portfolio.

But in assessing their exposure to emerging markets, investors need to distinguish between the economic opportunity and the market opportunity.

While countries like Brazil, Russia, India and China take up a greater share of world GDP, their listed equity markets are relatively undeveloped and still represent a relatively small slice of global market capitalisation. Basing an investment strategy purely on size of each country's economic output may be a legitimate choice, but it is a riskier one.

What is more, emerging markets have different characteristics to developed markets and should be seen as a separate asset class. While they offer higher expected returns, they also are more volatile. The best approach to this asset class is to employ strict controls to ensure adequate diversification and to protect the interests of investors.

Lastly, in a globalised world, investors need also remember that they can get exposure to the economic successes of these new markets both through the offshore listings of their native companies and through companies in developed markets with significant revenue in developing economies.


1Quick Reference Tables, The World Bank, September 2009

2MSCI Barra

3Emerging Markets: Practical Considerations, Karen Umland, Dimensional, 2003

4BHP Billiton preliminary results, June 30, 2009

5Parliamentary testimony, Reserve Bank of Australia, Aug 14, 2009, Hansard

6S&P-500 Global Sales, July 14, 2009

Posted by: Scott Keefer AT 09:27 pm   |  Permalink   |  Email
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