In the past two to three decades, international equity investing has changed in structure. This is mostly due to the fact that correlations between global markets have become more closely integrated, which means that investing in another country may not be worth the resources that are allocated for it. The arguments for global portfolio diversification tend to be centered on decreasing portfolio risk or increasing portfolio expected return relative to a comparable domestic portfolio.
What actually happens with the inclusion of global equities is that the efficient frontier shifts out and enables the investor to reap higher returns for given levels of risk or lower risk for given levels of return. In theory, global equity investing has its benefits. The data show that an international portfolio provides slightly more return and less risk than a domestic one over a given period. Thus, passive global strategies can lower risk for a given level of return as compared to a domestic portfolio. In global equity investing, we can separate investments into three markets: developed markets such as New York and London, emerging markets like those in Mexico and Brazil and frontier markets which include those in the Caribbean and Africa.
Emerging markets are defined as markets, not included in major international equity market indexes yet, that have significant economic activity and that may be suitable for institutional investment. Although the approaches to evaluating these investments are fundamentally equivalent, there is a perception that investing in emerging and frontier markets entails more risk. Issues that are included in investing in emerging markets include property rights, liquidity risks, transparency issues, availability of information and shareholder treatment. Another avenue for potential diversification is investments in small-capitalization international equities.
At the very least, the inclusion of such stocks in the portfolio would lead to increasing return per unit of risk or lowering risk per unit of return. Given all these choices and the differences between capital markets, how do we then address the challenges of active global/ regional management? The first problem that is faced by international equity investments is that the increased correlation in global markets have reduced the possible effects of synergy, but not eliminated them. As such, it is still possible to find equities that have low correlations, but the trade-off is that it has become much more costly to do so.
Another issue is that when we go out of the domestic market, we become exposed to currency risk. For example, a Jamaican investing in London would be exposed to the volatility of the pound sterling. The active portfolio manager must decide on its hedging policy. Will it cover 100% of his exposure, 75%, 50%, or should he not hedge at all? Studies have shown that a 100% hedging often does not reduce risk at all over long horizons, and may in fact increase it. The basic reason is that hedge returns are driven by different factors over different time horizons, and hedges do not protect against the risk factors affecting long-term exchange rates. As such, the benefits of hedging, which are short term in nature, diminish beyond a year or two.
On the other end, the long-term benefits of 0% hedging are not too acceptable to most fund managers. Imagine a pension fund that should be investing for the long-term, but the plan-sponsors evaluate the fund managers on a short-term basis. This would force the fund managers to want to protect short-term profits. Currency hedging has two effects on the global portfolio. The first is that it reduces volatility, while the second is that it increases correlation with domestic assets.
There are a few things to bear in mind in designing a global investment portfolio. One is the need to understand the volatility of the currency and the different accounting conventions used in different countries. The different accounting methods can create misinterpretation of the data found in the company’s financial statements.
Second, we need to assess where important secular changes may have occurred that could accelerate or decelerate a country’s growth.
Implementation
It is most likely that the optimal asset mix is different from the one that the investor currently holds. The reallocation of assets to that “optimal” mix would entail transactions costs. Thus, it would only be beneficial to reallocate assets when the benefits exceed the cost. However, the cost-benefit trade-off is not easily measured. We know that the benefits of a better asset mix can improve expected utility over several periods, while the transactions costs are just one-time current outflows.
Fixed income portfolio management
After we have decided on the asset mix, we now have to select the portfolios of the asset classes chosen. The emphasis of the section is on identifying, measuring, and controlling the risk and return characteristics of the different available portfolios. We shall then choose the one that is the best fit to the objective of the investor. A fixed income portfolio is one component of the total portfolio, where the amounts invested in the fixed income portfolio would depend on the investment objectives of the investor and the investment policies commensurate with those objectives. Thus, the problem of fixed income portfolio construction is to select debt instruments that would offer the highest total returns for a given level of risk, or the lowest risk for a given total return.
DEBT: Buy-and-hold strategy
A buy-and-hold strategy essentially means buying and holding the security to maturity or redemption, and then reinvesting the securities. The cash inflows and outflows consist of the coupon income and the reinvestment of those coupon payments. A buy-and-hold strategy reduces any need for creating expectations about risk and return given different levels of future interest rates. This is because when we keep the bond until maturity, we will redeem the face value of the bond and the capital gains or loss is computed using that amount. Therefore, the return on the portfolio is dominated by coupon income and reinvestment proceeds. The level of interest rates is delegated a secondary role as a guide to the credit risk of the issuer.
This means that the higher the yield that is required for the bond (if traded) then the credit quality of the issuer may be deteriorating and default may be forthcoming.
In general, those who follow a buy-and-hold strategy are those that view fixed income instruments as safe assets with predictable cash flows and low price volatility. They may be waiting to use the coupon income for reinvestment or other purposes. As such, they are willing to accept less than maximum return to avoid the risk that comes with attempting to achieve higher returns. In reality, many individuals fit in this category. For example, some people say that they want to be rich enough to live off interest alone or that someone is so rich that he is only living off the interest that he earns. Well, taking this in the context of bond portfolio management, this means that the person has invested funds in a fixed income portfolio that pays coupon income every so often. The investor then just uses the coupon income without having to sacrifice any principal, and then just invests the maturity value in another fixed income instrument. Since the investor may be thought of as quite risk averse, the securities that should be held would most likely be high-grade or risk-free fixed income instruments. The main concern is that default risk should be low. In addition, the requirement to have regular coupon income would reduce the desirability of instruments that yield uncertain cash flows.
Some investors following buy-and-hold strategies may have certain objectives in mind for their funds. Parents wanting to put up money for their child’s tuition for college can exemplify this strategy. Let us assume that the requirement for college tuition is GY$200,000 ten years from now. If the yield today for a 10-year zero coupon bond is 6%, the amount of funds that must be invested by the couple today is approximately GY$111,679. We can also see that this can be extended to retirement funds instead of funds for tuition. A buy-and-hold strategy would minimize transactions costs, because it does not require the investor to reallocate his or her portfolio whenever there are changes in capital market expectations. However, in return for this lower transactions cost, the investor gives up higher returns.
DEBT: Active strategies
When you employ any strategy that is not completely active, you must give up some of the total return. The reason is that the passive investing portion of your strategy would result in you missing out on certain total return enhancing transactions. However, also with the reduction in total return, you also reduce your risk level.
Thus, for those seeking the highest possible return, active strategies offer the greatest opportunity and commensurately greatest risk also. In maximizing total return, the objective could be either maximizing capital gains or income or a combination thereof. Pension funds and mutual funds embrace this approach because of their willingness to make assumptions about the future. The more accurate these predictions are, the higher their returns will be. The dominant forms of active strategies are interest rate anticipation and sector/security strategies. The objective of interest rate anticipation is to take advantage of expectations of interest rate change by managing the duration of the portfolio. Thus, interest rate anticipation should be concerned with 1) direction of the change in interest rates; 2) magnitude of the change across maturities; and 3) the timing of the change. For example, when interest rates drop, the price of the bond will increase to reflect the new yield level. The amount of price increase would depend on the duration of the security. In general, duration should be increased when rates are expected to drop and the opposite action should be taken when rates are expected to rise. The greater the shift in the duration prior to the actual change in yield, the greater the return.
Timing is one of the most important things in active bond management. You have to make informed decisions at different points along the time horizon. When you inaccurately time your moves, this results in a lower realized return for the period.
In addition, interest rate anticipation is not a one-time event. After the first rate change, you have to anticipate when the reversal will occur.
Beyond rate anticipation there is the possibility of enhancing returns by evaluating individual securities and subgroups of securities. This comes in three forms: credit analysis, spread analysis, and bond valuation.
Credit analysis is concerned with default risk. Default risk is important because of 1) the chance of loss due to actual acts of default and 2) the likelihood of adverse bond price changes that are precipitated by any increased probability of default. Then there is the unique risk, which can be diversified away by holding a diversified bond portfolio, and the effects of systematic risk that creates a huge impact on all firms. An important source of credit risk is through the work of credit rating agencies, such as CariCris, S&P, Moody’s, and Fitch’s. In most instances, investors complement the ratings of the agencies with their own credit analysis.
Equity portfolio management
Equities, cash and bonds have had low correlations in the past, and this means that one can reap the benefits of diversification by holding bonds, stocks, and cash in their portfolio.
Passive equity strategies
The difference between a passive manager and an active manager is that the active manager believes that he can add value either by timing the market, picking out the correct theme (e.g. small cap rather than large cap), or selecting correctly individual stocks. Any other strategy that does not engage in these three can be classified as passive. Passive management is a strategy for holding a portfolio of generic securities, without attempting to outperform other investors through superior market forecasting or superior ability to find mispriced securities. Often, although not always, a passively managed equity portfolio is well diversified.
Active equity strategies
Despite the rise of passive strategies, the majority of equity assets continue to be actively managed. Each manager can apply different investing styles. You can either be value, growth, or whatever mix in between that you so desire.
Portfolio risk management
When we talk about a multinational corporation, one can think of their various businesses as part of a portfolio. For example, a multinational firm has businesses in Jamaica, Trinidad and Tobago, and Barbados. One can think of the individual countries as part of a portfolio that they can manage in different ways. One way to manage this type of risk is through what is called multilateral netting. For example, if we are talking about currency risk, multilateral netting means that you would net out the dollar inflows and outflows from all the individual country offices and just hedge the excess portion. A centralized risk management office can do this.
Sometimes, multinational firms delegate the responsibility for risk management to their individual offices. In which case, the responsibility for hedging of individual risks becomes that of the subsidiaries’ executives. There are advantages and disadvantages to each. In a centralized system, corporations get to efficiently and cheaply manage the exposure. In an individual country system, the advantage is that they know the country more and that the need for hedging may be reduced by that.
Another possibility is that when your firm borrowed money in the domestic market, you only had the option to avail of a floating rate loan whereas you would actually prefer to have a fixed rate liability.
