The wisdom of buying international equities has come under scrutiny in the wake of the global financial crisis.
Several financial advisers have questioned the value of placing clients' money in funds that purchase stocks of companies domiciled in hard-hit regions, including North America, Europe and parts of Asia.
The economies of Spain, Britain and the United States have teetered on the brink of collapse after their financial systems buckled under the weight of an imploding housing market, ailing banking system, a global credit crunch and a collapse in world trade.
Several emerging markets have fared even worse. Eastern European countries, including Ukraine and Latvia, have sought billions of dollars in emergency loans from the International Monetary Fund (IMF) to stem a run on their respective currencies.
The MSCI World Index hedged into Australian dollars plunged 40.49 per cent in 2008. Country-specific gauges also slid, including France's CAC-40 and Germany's DAX-30, which plummeted 43 per cent and 40.8 per cent respectively in 2008.
The declines on average have not been drastically different to the local S&P/ASX 200 Index's 41 per cent slide in the same period.
The gross domestic product (GDP) of advanced economies on aggregate is expected to contract 3.8 per cent in 2009, before expanding 0.6 per cent next year, the IMF said in July.
"The global economy is beginning to pull out of a recession unprecedented in the post-World War II era, but stabilisation is uneven and the recovery is expected to be sluggish," the IMF said.
"Financial conditions have improved more than expected, owing mainly to public intervention, and recent data suggest that the rate of decline in economic activity is moderating, although to varying degrees among regions.
"Despite these positive signs, the global recession is not over, and the recovery is still expected to be slow, as financial systems remain impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings."
In the meantime, the Australian economy has remained remarkably resilient given the immense stress endured by global capital markets in the past two years.
Some market observers are forecasting local unemployment to stabilise at just 6 per cent, compared to around 10 per cent in the euro zone and US.
There has been no sub-prime lending disaster in Australia and the banks have not required any government funding.
Australian output in the next several years is expected to be superior to that of other advanced economies due to large infrastructure spending plans outlined in the government's fiscal stimulus package announced in February, and continuing healthy resources demand from Asia.
So this has thrown up the question: Why shouldn't portfolios constructed by dealer groups and advisory boutiques adopt a home bias when making asset allocation decisions, given the exceptional strength of the Australian economy?
More attractive valuations
Zurich Investments senior investment specialist Patrick Noble argues that there is a much larger set of investment opportunities offshore.
"The Australian market is dominated by financials and resource companies. Investing globally opens up opportunities to invest in sectors such as information technology and healthcare companies, which are not as prevalent locally and in emerging economies," Noble says.
"While many funds may have disappointed over the past 10 years, some benchmark-unaware managers have been able to generate positive returns by steering clear of the destructive impact of the tech wreck and by defensively positioning their portfolios against the looming threat of an unsustainable credit cycle.
"As such, diversification and investing in global companies at attractive valuations remain sound reasons to invest in international shares."
The Zurich Investments Global Thematic Share Fund, whose investment manager is Lazard Asset Management, has around $1 billion in funds under management (FUM).
The product gained 5.53 per cent a year in the five years to 31 August.
"Furthermore, global companies can be more attractively valued than their Australian peers," Noble says.
For example, in the Australian energy sector the choice of large-cap stocks is limited to Woodside Petroleum, Origin Energy and Santos, which all trade at price-earnings (PE) multiples of above 20.
Global investing can open up the opportunity set as it introduces other attractive companies, including Houston, US-based ConocoPhillips, which recently traded on a PE multiple of just 7.8. Conoco is a large-cap integrated oil company, meaning it explores for and produces oil and gas, does its own refining and also sells it to the end consumer via petrol stations - a business model non-existent in Australia.
Billionaire investor Warren Buffett's Berkshire Hathaway last year boosted its stake in the oil giant.
Benefiting from global trends
International shares should not be that foreign, Noble adds. In some way, people are likely to use products of global companies on a daily basis, from Microsoft and Google or Procter & Gamble products such as Pantene shampoo or Oral-B toothbrushes, he says.
Another key benefit Australian investors can tap into through global investing is access to industries and investment opportunities that are either too small or simply non-existent locally.
"Investment in intergenerational assets, such as energy infrastructure, which has not been renewed for many years, and the environment, have emerged as both key challenges and opportunities," Noble says.
"Investing globally means Australians can get exposure to world-class companies, such as ABB and Vestas Wind Systems, who can benefit from the push towards energy efficiency and renewable energy."
Switzerland-based ABB is one of the world's largest engineering companies and a global leader in power and automation technologies that can both increase energy efficiency and lower the impact on the environment, Noble says.
Denmark-based Vestas is a global leader in wind powered turbines and is set to profit from a regulatory push towards renewable energy, and is another good example of an industry that is not directly available to Australian investors, he says.
The Zurich Investments Global Thematic Share Fund's top three holdings are China Overseas Land and Investment (COLI), Andarko Petroleum and Hong Kong Exchanges and Clearing (HKEC).
"COLI has a significant land bank of over 25 million square metres covering key mainland China regions. The company has a strong earnings profile, with a gross margin of over 35 per cent," Noble says.
"Andarko is one of the world's biggest independent oil and gas exploration and production companies with assets spanning onshore US, the Gulf of Mexico and other emerging deepwater basins globally.
"In addition to Andarko's large reserves, it also has a strong track record in exploration, with recent success in Brazil, Ghana and deepwater Gulf of Mexico. Thematic managers see energy as a scarce and geopolitical commodity.
"HKEC is uniquely placed to benefit from the growth of Greater China's capital markets and its earnings are expected to rebound as daily turnover recovers from the lows of the financial crisis, public listings and new offerings such as exchange-traded funds."
A thin slice of the global market
Asset management firm Legg Mason's Safa Muhtaseb says investing worldwide offers many benefits, including diversification and exposure to other sectors, geographies and less cyclical economies.
"Australia, while a great, thriving, wealthy and growing nation, represents less than 5 per cent of the global equity market," Muhtaseb, a portfolio manager at Legg Mason-owned investment boutique Global Currents, says.
"Furthermore, Australia's economy is more highly skewed to materials and financials compared to other major economies.
"Australian investors can access household names that match their everyday spending budget, like Kraft and Procter & Gamble. They cannot access these names through an Australian equities portfolio."
Muhtaseb helps manage the Legg Mason Global Value Equity Trust, a recent addition to research house van Eyk's multi-manager Blueprint International Shares Fund.
"A well-structured global equity strategy generally provides exposure to varying economies, sectors, countries, currencies, market capitalisations and investment styles," he says.
"Additionally, investing outside Australia enables investors not only to reduce overall portfolio risk but also exploit valuation and/or under-appreciated growth elsewhere and therefore diversified sources of returns.
"As an example, including emerging market equities can offer a whole new dynamic to the portfolio that is not achievable from an Australia-only portfolio."
While Australia has been the only advanced economy to escape a recession amid the global financial crisis, its equity and currency markets fully felt the impact of the global onslaught, he says.
"Additionally, while indeed Australia has been one of the leading economies and markets in recovery, the fact that other markets have lagged presents opportunities for Australian investors," he says.
A recovering US economy, distressed valuations in Europe and above average growth in Asia and the developing world are some of the investment opportunities the team managing the Legg Mason Global Equity Value Trust see in the next three years. The product's top three stock choices are Bank of America, Schneider Electric and ASM Pacific.
Bank of America trades at a discount to normalised earnings power, Muhtaseb says.
Rueil-Malmaison, France-based Schneider, a world leader in energy infrastructure and management, has a depressed valuation after the crisis that does not reflect the company's growth opportunities and franchise power, he says.
ASM Pacific is a powerful play as capital expenditure in the semiconductor sector recovers, Muhtaseb says.
Unique commodity plays offshore
It is hard to go past the Australian market when looking to invest in the resources sector. The S&P/ASX 200 Index contains world-class companies including BHP Billiton and Woodside Petroleum.
Still, asset manager Colonial First State (CFS) head of global resources David Whitten says Australian listed mining stocks only make up 16 per cent of the global mining sector, while local oil and gas stocks account for under 6 per cent of the global energy market, underscoring the depth of opportunities offshore in commodities.
"Not only are there more opportunities outside Australia, there are some commodities that you really can't get exposure to in the Australian market," Whitten says.
Whitten looks after the CFS Global Resources Fund, which has around $350 million in funds under management. The product surged 11.97 per cent a year in the five years to 31 August 2009.
"Take Petrobras for example, the Brazilian oil giant. This is one of the highest-quality producers of oil in the world with low costs of production," he says.
"The real upside is its exposure to the Santos and Campos basins. This new oil province has yielded the largest oil discovery in almost 50 years some six kilometres below the surface."
Related investment opportunities in the oil sector include service companies, he says. "Many of the latest oil discoveries have been deep in the ocean, requiring specialist drill ships and equipment to evaluate and extract the oil," he says.
"With the global need for oil, these reserves will be tapped and the suppliers of this capital equipment will benefit.
"Companies include Noble Corporation, a US company that specialises in deep-water drilling. This company is leveraged to the level of activity in the oil industry, which is driven by the oil price.
"This type of investment is unobtainable, for now, for investors who limit themselves to the Australian market."
Canada's oil sands, Chinese coal
Additionally, alternative oil sources such as the Canadian oil sands industry can only be tapped by investors in global markets, Whitten says. "Similarly, there are limited alternative energy companies like solar and wind listed in Australia, but internationally there are many," he says.
"There are also several sectors where there may be some exposure in Australia, but the best opportunities, in terms of asset quality and size, are found offshore."
These include sectors such as uranium, which includes Canada's Cameco, one of the world's largest uranium producers, he says.
Another opportunity is in platinum, with Impala Platinum and Anglo Platinum being large producers listed in South Africa.
"Diversification across the commodity type is not the only benefit from going global. The best way to access the growing economies of China and India will be through local players," Whitten says.
"The local companies not only enjoy a cost advantage through reduced transport, there are often incentives for the local players to grow and supply the industry.
"When it comes to supplying coal to China, whilst Australian companies are likely to always have a role, China Coal and China Shenhua are better situated and provide a good opportunity for long-term investors."
Access to rocket motors through global small caps
BlackRock Investment Management Australia vice president James Holt says another set of investment opportunities that exists offshore is within global small and mid-sized companies.
"There are almost 10,000 companies in the S&P MidSmall Cap Index, which covers the lowest 30 per cent of market capitalisation globally and is the universe that we look at," Holt says.
"It also compares with only 1500 or so companies in the global large-cap MSCI World Index." An argument for considering investment in global small companies includes the fact that many of them operate in niche markets and technologies, whereas a lot of Australian smaller companies are focused on mining and energy activities.
For example, some of BlackRock's top picks include Minnesota, US-based Alliant Tech Systems and Venlo, Netherlands-headquartered Qiagen.
Alliant is the only company that manufactures the reusable solid rocket motor, which is used to launch NASA's space shuttles.
In the molecular diagnostics market, Qiagen's technologies are used in hospitals and medical laboratories to identify diseases or infections based on their genetic footprints and to develop adequate therapies.
Holt helps manage the BlackRock Global Small Cap Fund, which has over $300 million in FUM. The product jumped 7.23 per cent a year in the five years to 31 August 2009.
Another benefit that global small caps can bring to an investor's portfolio is that company sizes are large compared to their Australian counterparts.
"Our S&P MidSmall Cap Index includes companies ranging up to $10 billion in market cap," Holt says.
"In addition, we include emerging as well as developed markets - they are an increasing part of our investment universe.
"Some of the most successful companies in years to come are no doubt starting out as small companies in emerging countries."
Superior returns, commensurate volatility
Holt also argues that global small caps offer higher returns with not much more volatility than those of their large-cap peers.
"Over the 15 years ended 31 August 2009, the S&P Extended Market Index of small companies returned 141.2 per cent (6 per cent per annum) versus 99.5 per cent (4.7 per cent per annum) for the MSCI World Ex-Australia Index of global large-cap shares," he says.
"The volatility of those small-cap shares was 14.3 per cent per annum over that period versus 13.3 per cent per annum for large-cap shares.
"In short, global small companies offer higher returns along with a commensurate level of volatility."
It is also important to note that global small caps perform in very different cycles, Holt says.
"Small companies actually underperformed large caps in the lead-up to the tech wreck of 2000, but small caps strongly outperformed large caps in the six years after the collapse of the Internet bubble," he says.
"Contrary to myth, small caps actually have lower levels of debt than large caps and trade close to underlying asset valuations.
"It is noteworthy that during the global financial crisis the weak link in financial markets turned out to be large-cap banks and insurance companies, reminding us that big is not always better or safer.
"In fact, global small caps have outperformed large caps in all market recoveries in recent times."
Another source of diversification
Although adding global small caps to a client's portfolio is dependent on their risk profile and personal circumstances, it generally is another form of diversification, Holt says.
"If an investor has three or four global equity funds, then making one of them a GSC (global small-caps) fund makes sense," he says.
"They will source returns from a whole category of up-and-coming global stocks that large-cap fund managers tend to ignore or have less exposure to.
"Remember, every large company started out as a small cap once; better to have some exposure to them early than until after they have achieved success."
BlackRock's global small-cap team sees investment opportunities in emerging markets over the medium and long term, he says.
"Consumers in the developed world have become highly indebted after many years of borrowing. With the biggest financial crisis in 70 years triggering a major recession and high levels of unemployment, we're conscious that it takes a long time for economies to fully recover from these episodes," he says. "By contrast most emerging countries have become the workshops and exporters of the world and their domestic consumers have lots of savings and low levels of debt. They can significantly step up their activities.
"For example, in China, sportswear manufacturers like Anta Sports, who supply shoes to Nike, have quickly adapted their export models to the domestic economy where sportswear sales to the middle class are growing at a rapid pace."
Research house views
The biggest headache when it comes to asset allocation is how much and why?
In August, Lonsec raised Australian and international equities to neutral from underweight and suggested cutting cash holdings to overweight from very overweight.
The research house was more likely to increase its Australian equity weighting than its international equity weighting in recognition of the strong fundamentals of the Australian economy and a concern the Australian dollar would keep rallying and diminish gains in unhedged international share products, Lonsec senior equity strategist William Keenan says.
However, Morningstar recently boosted its allocation to international equities over Australian shares after reviewing its strategic asset allocation.
"While Australian equities have higher expected returns than international equities taking into account franking credits, they also have a higher risk profile and therefore higher standard deviation," Morningstar consultant Sallyanne Cook says.
The higher risk profile of the S&P/ASX 300 Index is in part due to the more concentrated nature of the index and its large exposure to more volatile resources stocks. While the S&P/ASX 300 Index has hefty weightings to the materials and financials sector, the MSCI World Index is much more diversified with exposure to a broader mix of industry sectors such as financials, energy, industrials, information technology, consumer staples and consumer discretionary.
"International diversification can provide exposure to companies and industries that are simply not represented in the local economy, such as software, aerospace and pharmaceuticals," Cook says.
"Investors are seeking the highest expected returns for the least level of risk.
"This translates into building a well-diversified portfolio of lowly-correlated assets, so intuitively it makes sense to allocate more to international shares as there's a larger spread of countries and industry sectors to choose from."
Although she says Australia has been remarkably resilient by avoiding the worst of the global financial crisis and the dotcom bubble, she stresses it could have been vice versa.
Aussies use same shampoo, search engine
Cook also argues that people live in a globalised world, so there is no reason for investors to not have a globalised portfolio.
"Many international companies are also household names in Australia. For example, a lot of people use products from Cadbury, Johnson & Johnson, Microsoft and Google, which are all international companies," she says.
"So if you want to have exposure to these stocks you need to go offshore."
The hedging decision is dependent on investors preferences, she says, but Morningstar prefers unhedged international share exposure because currency is a zero-sum game.
"At the end of the day it washes out over the long run," she says.
"International shares have performed very well in the 2003 to 2007 bull market, but the US dollar has underperformed the Aussie, so that has offset a lot of the stellar returns that we've seen from unhedged international equities funds," she says.
"But in our view, currency is a zero-sum game. At the end of the day it washes out over the long run."
Currency risk is also prevalent in Australian companies including BHP Billiton and Qantas.
"Their bottom line performance is also impacted by the fortunes of the Australian dollar, so currency risk is not just limited to international equities," Cook says.
As Noble, Muhtaseb, Holt, Whitten and Cook have put it, there is a vast array of industries and sectors that can only be accessed by investors prepared to accept a global view.
While recent data has painted the picture that many global equities have underperformed their Australian counterparts in the past several years, it is important to note that both asset classes have constantly rotated with each other in terms of the better performer over the very long term.
Despite Australia being one of the better-placed advanced economies given that it avoided the worst of the economic downturn, it can also be argued that adopting a home-bias approach exposes investors to the risk and reliance of the cyclical materials and financials sectors, which make up over half of the S&P/ASX 200 Index.
Global investing can arguably reduce that risk, given the breadth of industries and choice available in international markets.
Many commentators have also noted the depth of value and opportunities still available in many global stock markets despite their rebound since March, with American giant Kraft Foods announcing a monster $19.6 billion bid for confectioner Cadbury earlier this month.
