Sunday, May 31, 2015

Investing in World Equity?


A study of flows within the global mutual fund business shows that money is flowing into investments outside of one’s own country at a faster rate than being invested internally within the home country. This is not a new phenomenon. For probably the first 200 hundred or so years the US was being built with capital from overseas. Even in the 1920s, I am told that my Grandfather’s firm had one or more branch offices or correspondents in Europe to service European investors and traveling Americans who wished access to the US markets.

A lot of money has been made investing outside of the US in 2015. This is particularly true in local currency terms. According to The Economist, eight separate markets have gained more than 20%, compared with 3% in the US.  The reason this is important to US investors is at the bottom of the market, the locals will set the terminal prices.

My early career exposure to overseas investment

As a trust bank trainee, one of my jobs was counting the foreign stock certificates behind each of the American Deposit Receipts (ADRs) that the bank was issuing for foreign corporations to US investors. One of my mates at the counting table said that we were both likely to be involved with international investing later. He became the research partner for a highly respected London headquartered fixed income shop and at an early career opportunity I joined a small splinter analyst group focused on international investing. My next job was with a brokerage firm that among other things was institutionalizing some foreign corporations to the US market. At the time, while I was following what we called electronics companies, I was asked to sit in on the internal discussions on a major European electronics company. One of the things that hit me as odd was that every morning my firm was buying shares in the company’s local market to sell to Americans. I kept on asking if this is such a good deal for American investors why are the locals selling? Initially it turns out that I was correct. The locals were reducing their holdings in a stock that periodically had falling spells. Perhaps with the proceeds of their sales they were buying some shares of the companies that I favored in the US. This particular dichotomy of judgments is driving this post.

My mutual fund lens

Subsequent to my time at the brokerage firm, I spent my career focusing on mutual funds registered with the US Securities & Exchange Commission as well as in other major countries. Initially my focus was as sales targets for my industrial company research. Later on I focused on selling performance, fee and expense data to the funds. This in turn led to a consulting practice largely focused on boards of directors, including CEOs. In order to understand my clients more fully I bought small amounts of the publicly traded shares of mutual fund management companies mostly in the US and in the English speaking world. Many of these shares are in the portfolio of the private financial services fund that I manage. Thus, I study the fund business on a regular basis.

Utilizing data from the Investment Company Institute (ICI), I have seen that the retail fund investor since 2001 through April of this year has multiplied their investments in World Equity funds almost 4X (to $1.54 trillion) compared with an almost double in Total Return equity funds ($ 3.25 trillion) and about 1.5X for Capital Appreciation funds. It is quite possible that some of the more speculative money in the Capital Appreciation funds chose to speculate in World Equity funds. Institutions using institutionally priced mutual funds have built their world equity positions much faster than the retail investor, multiplying their 2001 base 13.56 X to a $ 749 Billion at the end of April 2015. Thus as far as the US fund business is concerned, approximately 1/3 of World Equity funds are owned in institutional funds.

Is institutional ownership good for world equity owners?

That depends on the dichotomy mentioned in my prior research experience. The retail investor has been reducing his/her more speculative exposure by being net redemption for at least 15 years in terms of Capital Appreciation funds. For their retirement and more conservative investing they have been redeeming only since 2007. What is more difficult to fathom is their behavior in World Equity funds. In 2006 they added $121 billion and $115 billion, in the following year only to be followed with a net withdrawal of $85 billion in 2008. This seesaw pattern was repeated in net redemptions in 2011, -$43 billion and $31 billion in 2012 which was followed by net purchases of $56 billion in 2013. These repeated swings could well be tied to dramatic changes in the value of the US dollar and gold. What is more hopeful is that over the entire period institutional World Equity funds had positive net flows.

World Equity
funds Flow
(in $ Billions)
+ $121
+ $115
-  $ 85

- $ 43
- $31

Mutual recognition of mutual funds in China and HK will allow the sale of locally-registered funds in each market.  This may have an impact of bringing more money to be invested in China.

What the gyrations of net flows on the retail side may be focused on are the short-term views of some brokers or registered investment advisors. I believe that the institutions were focusing on both longer term timespans and lower valuations, ex-US. What buttresses this view is when I look at what is happening in the non-US fund business, I see that investors are investing beyond their home markets. Part of this is practicing sound global diversification. Part may be in recognition that in general, the rich in any country tolerate their governments, but it is difficult to find a country that is happy with their present government. The current one is better than alternative for the most part.

What should be done now?

To some degree any domestic or foreign investment in the summer of 2015 should have a view on Germany, China, and India. On my recent trip to Germany I was impressed with the feeling of orderliness and a very strong desire for control. Many of their businesses have the attitude that they will not put a product on the market unless it is the best that can be produced within a price/quality range. There is not the rush to gain the first movers’ sole position in the race. If they can maintain control, investing in Germany (particularly in its middle market size companies) should be comfortable. The issue of control of Germany’s environment is critical. German investors’ fears are three. The first is to keep the Euro reasonably intact. The absence of a central currency will drive a huge flow into a German currency which will create an unmanageable inflation. The second is to keep Russia and the sanctions directed to it in proportion. A collapse of the Russian economy would hurt German companies as well as raise potential military stress. The third is to continue to keep ethnic unemployment low enough to prevent civil strife. Can they succeed with their three challenges? They have, but that is not a guarantee of the future.

I have said for some time that China is the single biggest economic/financial issue facing the world for the rest of this century. While the US, Japan, and Europe may think they are being bold with their levels of monetary experiments, China has many more moving parts to manage. Some of these are demographics. The one child policy means that their supply of cheap labor has peaked. The rapid urbanization to succeed required large scale infrastructure spending and an increase in the number of jobs with wages appropriate for urban living. The size of the provincial debt along with debts of government controlled banks will take great skill to avoid a financial collapse. The military/naval machine will need to be fed to avoid political problems. Solutions for ethnic and ecological problems can’t wait much longer. The enormous size of China’s internal market and their own trade ambitions are creating substantial opportunities for the world to participate in its growth. Simply put China can not be ignored.

On a gross basis India is growing faster than China. Whether the year-old government can encourage an in increase in productivity is critical. Skipping the landline phase in telecommunications will help as will some technological improvements in terms of electricity and drug production that need to be accelerated. Higher productivity requires lower levels of corruption and governmental controls. India already has the world’s largest middle class and an increasing number of highly educated workers.

Portfolio advice

Each investment activity that I analyze has a global aspect to it. Increasingly I segment portfolios into different risk classes, bearing in mind that risk is the size of the penalty for being wrong which affects future spending plans. If we live in an increasingly dynamic world we should be investing in securities that can manage change. While this favors stocks over bonds, it also introduces a bias in favor of mid to small companies that can make changes more rapidly than large companies that are too risk averse.

Question of the week:

Which are the companies that are likely to handle future change the best?     
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A. Michael Lipper, C.F.A.,
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