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![10 International Investing: An Independent Advisor’s Guide
Diversification Opportunities
Geographic Diversification
Political changes in the past twenty years have dramatically increased the number of countries available for
investment. Up until the fall of the Berlin Wall in 1989, the number of stock exchanges globally had remained
constant for decades. After the Wall fell, that number grew dramatically, more than doubling in two decades.
A 2007 Capco study presented a top-down analysis of the growth in exchanges at the country level.1
The
study used the International Standards Organization (ISO) list of 244 countries, of which the World Bank
had population and economic statistics for 2009. The findings from the study showed that in 1988, stock
exchanges existed in 63, or 26%, of the 244 countries. These countries comprised 58% of global population
and 81% of global gross domestic product (GDP, measured on the purchasing power parity [PPP] basis).
By 2005, there were national or regional stock exchanges present in 145, or 59%, of ISO-listed countries, which
together comprised 92% of the world’s population and 99% of global GDP (on a PPP basis). Another four
countries were planning to add exchanges at the time of the study: Libya, Cambodia, Sierra Leone and Gibraltar.
Exhibit 7: Number of Countries With Stock Exchanges
Source: Capco Analysis 2007
NumberNew
160
140
120
100
80
60
40
20
0
158517921808185018611869187518811890189419121929195319601969197519811986199019931996199920022005
Cumulative
Year
12
10
8
6
4
2
0
The remaining 95 ISO countries constitute only 1% of global GDP. There were 65 countries with
population counts that ranged from approximately 20,000 in Palau to 73 million in Ethiopia. The bulk of
these, approximately 50 countries, had populations under 10 million. The remaining 30 countries were small
islands with limited or no population. In summary, the study concluded that institutional and legal
frameworks and infrastructure for stock trading had been established in virtually all of the world’s significant
economies at that point.
This is significant in terms of assessing these countries from an investment perspective as long-term potential
growth opportunities. As the World Economic Forum states, “Stock market liquidity is statistically significant
in terms of its positive impact on capital accumulation, productivity growth and current and future rates of
economic growth. More generally, economic theory suggests that stock markets encourage long-run growth
1
See page 37 for Methodology.](https://image.slidesharecdn.com/73f49de3-8dfa-47b1-ab57-77d42c300dcc-160416094254/85/International-Investing-PAS-10-320.jpg)
![16 International Investing: An Independent Advisor’s Guide
Exhibit 14: Rolling 36-Month Correlation Between
United States and Developed Markets, Emerging Markets
Source: The World Is Not Enough?, MSCI Barra Research, July 2008
DM-EMUSA-EAFE USA-EM
100%
80%
60%
40%
20%
0%
Dec90Dec91
Dec07
Dec93Dec94Dec95Dec96Dec97Dec98Dec99Dec00
Dec02Dec03Dec04Dec05Dec06
Dec01However, as Exhibit 14 above shows, correlation between markets has not always been a straight-line
phenomenon, but instead is cyclical and marked by ups and downs. Taking the USA–Emerging Market (USA-
EM) series as an example (orange line in Exhibit 14 above), the correlation between the two peaked in 1993 at
approximately 65%; two years later, correlation had been approximately halved to 30%. Similarly, in 2004,
correlation for the series was approximately 80%; three years later it had dropped to approximately 60%.
As expected, the overall trend for the past decade has been up on an absolute basis; however, on a relative basis,
there are still periods of decreasing correlation, which have benefited investors with internationally diversified
portfolios. As long as there is a relative difference in the performance of U.S. and non-U.S. markets, (correlation
remaining below 100%), the benefits of diversification will still exist.
Developed and Emerging Markets—Trends and Opportunities
From 2003 to 2007, the global economy boomed for a sustained period. Global GDP rose at an average of
approximately 5% a year, its highest sustained rate since the early 1970s. About three quarters of this growth
was attributable to a broad-based surge in the emerging and developed economies.4
Events since the summer
of 2007 and through 2009 have significantly altered the global economic and investing landscape.
The economic crisis has had a significant impact on the global economy, especially in the emerging markets
that suffered a sharp reduction or redemption in capital flows because of the desire for capital protection.
Despite a 39% fall in the MSCI Emerging Markets Index, the emerging markets have grown by 93%
(Compound Annual Growth Rate [CAGR]) starting from 2003, as compared to the S&P 500®, which has
grown by only 6.5%. Thus, although the credit crisis and the subsequent events of 2008 have caused short-
term volatility and declines in emerging markets, long-term attractiveness remains.
4
World Economic Outlook, International Monetary Fund, October 2008.](https://image.slidesharecdn.com/73f49de3-8dfa-47b1-ab57-77d42c300dcc-160416094254/85/International-Investing-PAS-16-320.jpg)
International Investing PAS
- 1. International Investing An IndependentAdvisor’s Guide Our partner in developing this guidebook:
- 3. International Investing: AnIndependent Advisor’s Guide 3 Contents Executive Summary...................................................................................................................................................5 Understanding International Opportunities........................................................................................................6 Investment Returns—United States versus International................................................................................................................. 6 Case Studies in International Investing.................................................................................................................................................. 8 Diversification Opportunities.................................................................................................................................................................. 10 Instrument Diversification Opportunities.............................................................................................................................................12 Returns and Correlations in International Diversification................................................................................................................14 Developed and Emerging Markets—Trends and Opportunities.....................................................................................................16 Accessing International Opportunities.............................................................................................................20 Indirect Investment.....................................................................................................................................................................................21 Depository Receipts..................................................................................................................................................................................28 Direct Investment.......................................................................................................................................................................................29 Getting Started........................................................................................................................................................ 34 Risks Related to International Investing ..............................................................................................................................................34 Leveraging Pershing for Direct Investment.........................................................................................................................................35 Appendices................................................................................................................................................................37 MSCI Market Definitions.........................................................................................................................................................................37 Methodology...............................................................................................................................................................................................37 About the Authors..................................................................................................................................................40
- 4. 4 International Investing:An Independent Advisor’s Guide Table of Exhibits Exhibit 1: Real Returns of Equities and Bonds Internationally 1900–2007 Exhibit 2: Annual Total Returns (%) for U.S. Large Company, International and European Stocks Exhibit 3: Comparison of Returns In Equities and Bonds Across Different Regions, 2003–2009 Exhibit 4: Risks and Returns of U.S. and Global Portfolios Exhibit 5: HMC Asset Allocation 2009 Exhibit 6: CalPERS Actual Asset Allocation 2009 Exhibit 7: Number of Countries with Stock Exchanges Exhibit 8: MSCI Country Categorization Framework Exhibit 9: Establishment of Exchanges Over Time Exhibit 10: Percentage of Financial Assets Within MSCI Category Exhibit 11: Amount of Financial Assets Within MSCI Category Exhibit 12: Percentage of Market Capitalization by GICS Sector Exhibit 13: Factors Driving Risk and Return Exhibit 14: Rolling 36-Month Correlation Between United States and Developed Markets, Emerging Markets Exhibit 15: BRIC Index Versus G7 Index Monthly Performance Returns Exhibit 16: Contribution to Global GDP Growth, PPP Basis Exhibit 17: Emerging Markets with the Most Significant Moves in 2008 and 2009 Exhibit 18: Economic Forecasts Diverge over the Next Two Years Exhibit 19: Real GDP Growth BRIC Versus United States Exhibit 20: Projected Real GDP Growth BRIC Versus United States 2006–2015 Exhibit 21: Population and Wealth Comparison Exhibit 22: Growth in Purchases in Foreign Securities by U.S. Investors Exhibit 23: Number of International Fund and ETF Launches Per Year Exhibit 24: Distribution of Pooled Funds by Type Exhibit 25: Distribution of AUM by Type of International Index Mutual Fund Exhibit 26: Distribution of AUM by ETF Type Exhibit 27: Growth in International Investing Through ETFs Exhibit 28: Distribution of AUM by Type of Actively Managed Mutual Funds Exhibit 29: Summary Assessment of International ETF and Mutual Fund Options Exhibit 30: Fees on Pooled Funds by Region Exhibit 31: Depositary Receipts by Country Classification Exhibit 32: Growth in Annual Depository Receipts Trading Volume Exhibit 33: Developed Countries Direct Investment Exhibit 34: BRIC Countries Direct Investment Exhibit 35: Non-BRIC Emerging Countries Stock Exchanges
- 5. International Investing: AnIndependent Advisor’s Guide 5 Executive Summary Many investors today are considering the opportunities available to them through international investing products. Globally, major institutional investors have always allocated a percentage of assets to non-domestic instruments as a means to increase portfolio diversification, decrease risk and improve overall investment performance. In the United States, some of the most successful institutional investors have recently lowered the proportion of U.S. equities in their overall portfolios while growing their investments in developed and emerging markets. As well as investing in various geographical regions, these investors have also enhanced diversification by investing in instruments other than equities, including expanded opportunities across different industry sectors. Recent research from the International Monetary Fund (IMF) and others demonstrates the significant growth potential in the years ahead in the emerging markets of Brazil, Russia, India and China versus the developed economies of the United States, Europe and Japan. Traditionally, larger institutional investors have utilized a direct investment approach in international investing by buying and selling shares on local stock exchanges. For smaller institutional investors, indirect investing via pooled vehicles such as mutual funds and exchange-traded funds (ETFs) has traditionally been a more economical approach. ETFs have become an increasingly popular way to gain exposure to these markets; ETFs based on international indices have been some of the most popular products in recent years. However, these products focus primarily on the large-cap equities of international markets, and therefore can provide only limited portfolio diversification opportunities. A direct investment approach via the purchase of tradable instruments on local stock exchanges allows for more flexibility in an investment portfolio and can also provide access to a wider range of international instruments such as international bonds. This approach provides the ability to control underlying securities, which an ETF or mutual fund strategy does not, and mitigates the management and maintenance fees associated with these indirect investment vehicles. Another vehicle for investors to consider is the depositary receipt, which gives investors the option of investing directly in the shares of a limited number of foreign companies (as opposed to using a pooled fund) in U.S. dollars and using U.S. standard settlement processes. While international investing carries currency, liquidity, political and other unique risks, partnering with a service provider can facilitate the mitigation of these complicating factors. The right service provider can offer a complete range of trading facilities and operational support, with access to assets across multiple investment markets and features such as multicurrency support and reporting. Beyond operational infrastructure, firms can leverage a service provider’s local market knowledge and expertise on legal and risk management issues, thereby increasing investor confidence.
- 6. 6 International Investing:An Independent Advisor’s Guide Understanding International Opportunities Major institutional investors have long invested in international markets with the expectation that those assets will increase diversification in their portfolios, reduce overall risk and improve investment returns. Diversifying into different geographical regions and instruments has typically enabled these investors to see better investment performance than if they had remained solely invested in U.S. assets. Investment Returns—United States versus International Various studies through the years have compared investment returns in the United States versus international markets. For example, in 2006, the London Business School completed a study of investment performance across 17 major markets, for which data was available going back to 1900. Its findings show that the United States ranked fourth in terms of market returns. The best performers in terms of equities were Australia and Sweden, both of which had an annualized percentage real return of 7.6% compared with a global average of 5.7%. Exhibit 1 below shows the findings of an updated joint study between ABN AMRO and the London Business School, which found that the United States had annualized returns of 6.5% for equities and 1.9% for bonds, whereas Australia and Sweden still held strong at 7.9% and 7.8%, respectively, in the equity market. Exhibit 1: Real Returns of Equities and Bonds Internationally 1900–2007 Belgium Italy Germany France Norway Spain Japan Switzerland Ireland Denmark Netherlands United Kingdom Canada United States South Africa Sweden Australia 0 2 4 6 8-2 Source: ABN AMRO/LBS Global Investment Returns Yearbook 2008 Equities Bonds A 2008 study from Ibbotson Associates provides a similar story: $1 invested in 1969 in international stocks was worth $64.03 in 2007; for U.S. stocks, the same $1 was worth $54.05. Exhibit 2 shows the annual total returns of U.S. large company stocks compared to international stocks and European stocks from 1970 to 2007. Investment returns for U.S. stocks have lagged behind international and European stock performance since 2002.
- 7. International Investing: AnIndependent Advisor’s Guide 7 Exhibit 2: Annual Total Returns (%) for U.S. Large Company, International and European Stocks Source: Ibbotson Stocks, Bonds, Bills, Inflation 2008 Classic Yearbook U.S. Large Company stocks International stocks European stocks 100 80 60 40 20 0 -20 -40 1970 20071974 1982 1998199019861978 20021994 Another element of the international equation is that performance can be substantially enhanced through the inclusion of other international instruments, which can help to increase returns and lower risk. Exhibit 3 shows a comparison of returns in equities and bonds in a subset of key markets. The Sharpe ratio has been added, which measures the return received on the instrument versus the risk taken (as measured by the volatility of the instrument’s returns). The higher the Sharpe ratio, the better the returns are for each unit of risk. As can be seen in Exhibit 3, returns across asset classes have been lowest in the United States and higher in both the other developed economies and the emerging markets. In terms of the Sharpe ratio, bonds have performed better than equities in the last five years across all markets. Exhibit 3: Comparison of Returns in Equities and Bonds Across Different Regions, 2003–2009 Source: Capco analysis (please see Appendices for methodology and calculations) Equities Bonds Sharpe ratio All World United States Emerging Markets World (excluding United States) 4.5% 6.4% 1.2% 5.2% 7.7% 8.5% 15.8% 9.5% 0.24 0.95 1.2 0.38 0.73 0.73 0.93 0.06
- 8. 8 International Investing:An Independent Advisor’s Guide Constructing sample world portfolios illustrates this more clearly. Exhibit 4 shows two portfolios: P1, which represents U.S.-only equity and fixed income and P2, which represents a global portfolio with both U.S. and international equity and international fixed income. Exhibit 4: Risks and Returns of U.S. and Global Portfolios Comparison of risk and return profile of a U.S. balanced portfolio with a portfolio composed of U.S. and emerging markets Source: Capco analysis (please see Appendices for methodology and calculations) Risk (annualized standard deviation using monthly returns) October 2003 – September 2009 Return(annualizedcompounded returnusingmonthlyreturns) October2003–September2009 P2 8% 6% 4% 2% 0% 7% 8% 9% United States and Emerging Markets (EM) P1United States only Portfolio Composition P1 U.S. only portfolio: U.S. Equities 60% U.S. Bonds 40% P2 U.S. and EM portfolio: U.S. Equities 48% U.S. Bonds 32% EM Equities 12% EM Bonds 8% The sample illustrates that the U.S.-only portfolio, P1, has both lower returns, as well as higher risk than the global portfolio. Between the two portfolios, P2, which has an international mix of both equities and bonds, has a higher return with lower risk. Case Studies in International Investing Some of the world’s leading institutional investors provide effective case studies for the benefits of international diversification. Investors such as Harvard Management Company (HMC) and California Public Employees’ Retirement System (CalPERS) achieved in fiscal year 2008 significant returns of 8.6% and -2.4%, respectively; these are particularly impressive returns given that stocks were down over 10% in the same period. HMC had a relatively low investment in domestic equities and CalPERS showed a high percentage in international equities. HMC is an investment management company responsible for managing the $26 billion endowment of Harvard University. In fiscal year 2009, HMC increased its asset allocation in emerging market equity from 10% to 11%. Developed foreign market equity remained relatively stable, comprising 11% of the asset allocation, further indicating its commitment and confidence in investing internationally. In fiscal year 2008, emerging markets (7.6%) outperformed the benchmark (4.8%), while foreign bonds (21.3%) also outperformed the benchmark (18.5%). For fiscal year 2009, the endowment experienced a -27.3% rate of return; the annualized five-, ten-, and twenty-year performances have outperformed the benchmark, demonstrating that the recent year is a performance anomaly. HMC reports that the five-year annualized return is 6.2%, and the twenty-year annualized return is nearly twice as strong at 11.7%, further showing that performance has been positive during the long term.
- 9. International Investing: AnIndependent Advisor’s Guide 9 Cash 3% Absolute Return 18% Real Assets 26% Fixed Income 13% Private Equity 13% Emerging Markets Equity 11% Developed Foreign Markets Equity 11% Domestic Equity 11% Exhibit 5: HMC Asset Allocation 2009 Source: Harvard Management Company CalPERS is the largest defined benefits pension plan in the United States, with $180.9 billion in assets under management as of June 30, 2009. Although its asset value declined by 23.4% in the last year, CalPERS continues to show a strong long-run twenty-year performance, with a positive return of 7.75%. The June 2009 target asset allocation of foreign equity of 24.5% was consistent with that of the previous year, a further indication of confidence in the international markets. As shown in Exhibit 6, the actual allocation in international equity exceeds the targeted percentage. Moreover, CalPERS raised its alternative investment target in anticipation that the private equity market will bring about higher future returns. Exhibit 6: CalPERS Actual Asset Allocation 2009 Source: CalPERS July 31, 2009 Inflation Linked 3%Real Estate 9% Private Equity 11% International Equity 26% Domestic Equity 26% Global Fixed Income 24% Cash 1% The above examples from HMC and CalPERS demonstrate that international diversification has been a key component driving institutional investors’ investment returns. Importantly, this has included diversification into different geographical regions, instruments and sectors.
- 10. 10 International Investing:An Independent Advisor’s Guide Diversification Opportunities Geographic Diversification Political changes in the past twenty years have dramatically increased the number of countries available for investment. Up until the fall of the Berlin Wall in 1989, the number of stock exchanges globally had remained constant for decades. After the Wall fell, that number grew dramatically, more than doubling in two decades. A 2007 Capco study presented a top-down analysis of the growth in exchanges at the country level.1 The study used the International Standards Organization (ISO) list of 244 countries, of which the World Bank had population and economic statistics for 2009. The findings from the study showed that in 1988, stock exchanges existed in 63, or 26%, of the 244 countries. These countries comprised 58% of global population and 81% of global gross domestic product (GDP, measured on the purchasing power parity [PPP] basis). By 2005, there were national or regional stock exchanges present in 145, or 59%, of ISO-listed countries, which together comprised 92% of the world’s population and 99% of global GDP (on a PPP basis). Another four countries were planning to add exchanges at the time of the study: Libya, Cambodia, Sierra Leone and Gibraltar. Exhibit 7: Number of Countries With Stock Exchanges Source: Capco Analysis 2007 NumberNew 160 140 120 100 80 60 40 20 0 158517921808185018611869187518811890189419121929195319601969197519811986199019931996199920022005 Cumulative Year 12 10 8 6 4 2 0 The remaining 95 ISO countries constitute only 1% of global GDP. There were 65 countries with population counts that ranged from approximately 20,000 in Palau to 73 million in Ethiopia. The bulk of these, approximately 50 countries, had populations under 10 million. The remaining 30 countries were small islands with limited or no population. In summary, the study concluded that institutional and legal frameworks and infrastructure for stock trading had been established in virtually all of the world’s significant economies at that point. This is significant in terms of assessing these countries from an investment perspective as long-term potential growth opportunities. As the World Economic Forum states, “Stock market liquidity is statistically significant in terms of its positive impact on capital accumulation, productivity growth and current and future rates of economic growth. More generally, economic theory suggests that stock markets encourage long-run growth 1 See page 37 for Methodology.
- 11. International Investing: AnIndependent Advisor’s Guide 11 by promoting specialization, acquiring and disseminating information and mobilizing savings in a more efficient way to promote investment. Research also shows that as countries become richer, stock markets become more active and efficient relative to banks. Bond markets have received little empirical attention, but recent research has shown that bond market development does in fact affect economic output.” (World Economic Forum Financial Development Report, 2008). With so many investment options available, institutional investors have relied on various global investment frameworks and performance benchmarks to select in which countries to invest, set asset allocation strategies and evaluate their relative performance. One of the most common sets of frameworks and benchmarks for global investing is the Morgan Stanley Capital International (MSCI, now MSCI Barra) index. MSCI has developed frameworks for categorization of global economies, as well as stock market indices for multiple countries and assets. Exhibit 8: MSCI Country Categorization Framework Economy Region Countries Developed Markets North America – Canada – United States Europe – Austria – Belgium – Denmark – Finland – France – Germany – Greece – Ireland – Italy – Netherlands – Norway – Portugal – Spain – Sweden – Switzerland – United Kingdom Pacific – Australia – Hong Kong – Japan – New Zealand – Singapore Emerging Markets Latin America – Argentina – Brazil – Chile – Colombia – Mexico – Peru Europe, Middle East and Africa – Czech Republic – Egypt – Hungary – Israel – Jordan – Morocco – Poland – Russia – South Africa – Turkey Emerging Asia – China – India – Indonesia – Korea – Malaysia – Pakistan – Philippines – Taiwan – Thailand Frontier Markets Central and Eastern Europe and Commonwealth of Independent States – Bulgaria – Croatia – Estonia – Kazakhstan – Lithuania – Romania – Serbia – Slovenia – Ukraine Africa – Kenya – Mauritius – Nigeria – Tunisia Middle East – Lebanon – Bahrain – Kuwait – Oman – Qatar – Saudi Arabia – United Arab Emirates Asia – Sri Lanka – Vietnam Source: Morgan Stanley Capital International Index The MSCI framework used to differentiate the various investment markets available applies a set list of criteria to classify countries, primarily World Bank net income per capita, size and liquidity of corporate listings available, as well as market accessibility. (See Appendix 5.1 for details.) With this framework, MSCI has classified economies and their performance indices into three major tiers: Developed, Emerging and Frontier. The Developed Index series started in 1969, the Emerging Index in 1988, and the Frontier Index in 2007. The major indices in use today for benchmarking global investment performance are the World Indices
- 12. 12 International Investing:An Independent Advisor’s Guide (all developed markets), EAFE (Europe, Australasia and the Far East, or the developed markets excluding the United States and Canada), Emerging Markets, the All-Country World Index (which is the combination of all the developed and emerging markets), and the frontier markets. Combined, the countries in all three categories together represent only 68 of the 145 investable countries available. In terms of GDP and population, however, they represent 95% of global GDP and 80% of population, with the developed and emerging markets alone (48 countries) comprising the bulk of global economic activity: 92% of GDP and 73% of population. Over time, it is likely that frontier and other less-developed countries with exchanges will contribute a larger percentage to global GDP as their economies grow and mature. When the Emerging Markets Indices were first launched in 1988, they comprised less than 1% of total global stock market capitalization; by 2007, they were 11% of this total. The chart below shows the relative age of the exchanges, demonstrating that the majority of frontier and fledgling countries have only recently launched exchanges.2 As their economies grow and mature, these countries should begin to contribute more to global GDP growth, similar to the path taken by the emerging market countries. Exhibit 9: Establishment of Exchanges Over Time Source: Capco Analysis 2007 NumberofExchangesOpenedperYear 12 10 8 6 4 2 0 2007 Year Developed Emerging Frontier Fledgling 1770179218081850 186118691875188118901894 19121929195319601969197519811986199019931996199920022005 Instrument Diversification Opportunities As previously noted, diversifying across international instruments enhances investment performance by reducing risk and increasing returns. According to the World Federation of Exchanges, there were approximately more than 46,000 listed equities available globally and more than 140,000 listed bonds in 2008. On an over-the-counter basis, there are many more fixed income and derivative instruments available. 2 ‘Fledgling countries’ are countries with stock exchanges that are not officially part of the MSCI Frontier Index.
- 13. International Investing: AnIndependent Advisor’s Guide 13 In terms of the value of the assets available, total assets across the three MSCI segments were approximately $140 trillion in 2007.3 Equities were approximately $62 trillion and fixed income (public and private) was approximately $76 trillion. The developed markets still represent the majority of global assets, at 83% of the total. They also have a balanced mix of equity, private debt and public debt available for investment. Emerging markets are approximately 16% of total assets, and frontier markets represent 1% of total assets. In these sectors, equities are still the dominant vehicle, at approximately 70% and 78% of total investable assets, respectively; but there are fixed income opportunities in each of these sectors, as well. Exhibit 10: Percentage of Financial Assets Within MSCI Category Source: Financial Development Report 2009, World Economic Forum Equity Securities Private Debt Secutities Public Debt Securities Developed Markets Frontier MarketsEmerging Markets 100% 80% 60% 40% 20% 0% Exhibit 11: Amount of Financial Assets Within MSCI Category ($ Billions) Source: Financial Development Report 2009, World Economic Forum Equity Securities Private Debt Secutities Public Debt Securities Developed Markets Frontier Markets TotalEmerging Markets $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 $45,616.80 $15,720.00 $1,215.50 $62,552.30 $46,274.70 $2,467.20 $102.50 48,844.40 $23,334.10 $4,161.90 $238.60 $27,734.60 3 Financial Development Report 2009, World Economic Forum. Not all countries represented in sample: Developed = 20/23; Emerging = 23/25; Frontier = 8/22.
- 14. 14 International Investing:An Independent Advisor’s Guide Sector Diversification Another element to consider is the amount of sector diversification available in developed and emerging markets. The Global Industry Classification Standard (GICS) categorizes companies into ten investment sectors. As the chart below shows, emerging markets have investable companies in all ten, but they are more weighted towards materials (commodities) and energy than are the developed markets, which reflects their economic growth patterns. For example, in emerging markets, energy and materials are 31% of total market capitalization versus 15.7% in developed markets. Conversely, the consumer and health segments are much more dominant in developed markets, 28.1% of total, than in emerging markets, where they represent only 11.5%. For investors focused on sector-based investment themes, expanding the opportunity set to include relevant companies in emerging markets should be considered. Exhibit 12: Percentage of Market Capitalization by GICS Sector Percentage of GICS Sector Total Source: Emerging Markets: A 20-Year Perspective, MSCI 2008 Developed Emerging Health Utilities Consumer Staples Consumer Discretionary Industrials Telecommunication Information Technology Materials Energy Financials 9.0% 1.6% 4.6% 3.3% 8.4% 4.8% 10.7% 5.1% 10.2% 8.4% 4.7% 9.7% 10.1% 13.2% 6.2% 14.3% 9.5% 16.7% 26.8% 22.8% Returns and Correlations in International Diversification What Drives Returns in International Investing? The preceding sections outline diversification opportunities across geographical regions, instruments and sectors or industries. A fourth variable, style (value, growth, etc.), is also relevant depending on the investment strategy. For investors, an important question must be what component of this diversification drives the risk and return from the investment. A study undertaken by MSCI Barra decomposed the drivers of risk and return into three fundamental criteria: country factors (risk and return due to local conditions, including currency), industry and sector factors (risk and return of a company belonging to a particular industrial segment) and style factors (risk and return of a company belonging to a particular style). MSCI’s analysis showed that for the developing countries, represented here by EAFE, risk and return was almost equally due to country and industry factors, and less so for style. For the emerging markets, the majority of risk and return was due to country factors.
- 15. International Investing: AnIndependent Advisor’s Guide 15 Developed Markets (EAFE) Source: The World Is Not Enough?, MSCI Barra Research, July 2008 Style Share of Global Component Country Share of Global Component Industry Share of Global Component Exhibit 13: Factors Driving Risk and Return 100% 80% 60% 40% 20% 0% Feb 99 Apr 07Feb 01 Apr 05Mar 03 Cross-SectionalVolatility 12-MonthMovingAverage Emerging Markets Source: The World Is Not Enough?, MSCI Barra Research, July 2008 Style Share of Global Component Country Share of Global Component Industry Share of Global Component 100% 80% 60% 40% 20% 0% Feb 99 Apr 07Feb 01 Apr 05Mar 03 Cross-SectionalVolatility 12-MonthMovingAverage The Diversification Benefits of Correlation One of the primary benefits of international diversification is to enable investors to invest in assets whose risk and return profiles are driven by different factors—as one asset drops, another may be rising. However, the correlation of assets in different countries has been increasing in recent years, meaning that diversifying internationally appears to have decreased the opportunity for non-correlated returns.
- 16. 16 International Investing:An Independent Advisor’s Guide Exhibit 14: Rolling 36-Month Correlation Between United States and Developed Markets, Emerging Markets Source: The World Is Not Enough?, MSCI Barra Research, July 2008 DM-EMUSA-EAFE USA-EM 100% 80% 60% 40% 20% 0% Dec90Dec91 Dec07 Dec93Dec94Dec95Dec96Dec97Dec98Dec99Dec00 Dec02Dec03Dec04Dec05Dec06 Dec01However, as Exhibit 14 above shows, correlation between markets has not always been a straight-line phenomenon, but instead is cyclical and marked by ups and downs. Taking the USA–Emerging Market (USA- EM) series as an example (orange line in Exhibit 14 above), the correlation between the two peaked in 1993 at approximately 65%; two years later, correlation had been approximately halved to 30%. Similarly, in 2004, correlation for the series was approximately 80%; three years later it had dropped to approximately 60%. As expected, the overall trend for the past decade has been up on an absolute basis; however, on a relative basis, there are still periods of decreasing correlation, which have benefited investors with internationally diversified portfolios. As long as there is a relative difference in the performance of U.S. and non-U.S. markets, (correlation remaining below 100%), the benefits of diversification will still exist. Developed and Emerging Markets—Trends and Opportunities From 2003 to 2007, the global economy boomed for a sustained period. Global GDP rose at an average of approximately 5% a year, its highest sustained rate since the early 1970s. About three quarters of this growth was attributable to a broad-based surge in the emerging and developed economies.4 Events since the summer of 2007 and through 2009 have significantly altered the global economic and investing landscape. The economic crisis has had a significant impact on the global economy, especially in the emerging markets that suffered a sharp reduction or redemption in capital flows because of the desire for capital protection. Despite a 39% fall in the MSCI Emerging Markets Index, the emerging markets have grown by 93% (Compound Annual Growth Rate [CAGR]) starting from 2003, as compared to the S&P 500®, which has grown by only 6.5%. Thus, although the credit crisis and the subsequent events of 2008 have caused short- term volatility and declines in emerging markets, long-term attractiveness remains. 4 World Economic Outlook, International Monetary Fund, October 2008.
- 17. International Investing: AnIndependent Advisor’s Guide 17 Exhibit 15 compares monthly index performance returns for Brazil, Russia, India and China (BRIC) and G7 indices on a basis points measurement. The graph indicates that the emerging markets BRIC countries rebounded faster than the G7 countries since January 2009, which further shows that BRIC have been quick to recover from the downturn compared to the developed nations. During September 30, 2009, the BRIC Index returned 2.55%, which was more than double that of the G7 Index, which had a 1.02% return. Even during the lowest monthly return in February 2009, the BRIC Index had nearly double the returns of the G7 nations at 1.37% and 0.70%, respectively. The single-year annualized return, as of September 30, 2009, for the BRIC Index was 18.85%, while the G7 Index showed a -6.83% annualized return for the last year. Exhibit 15: BRIC Index Versus G7 Index Monthly Performance Returns Source: MSCI.com Index Performance, October 2009 BRIC G7 400 300 200 100 60 Sep 04 Sep 09Sep 06 Sep 08Sep 07Sep 05 BasisPoints In the years ahead, global growth will depend more on the emerging markets than the developed markets. Exhibit 16 shows that the United States has seen its share of global GDP slowly decrease from 1995 to 2009, while emerging countries, such as China, continue to grow. Exhibit 16: Contribution to Global GDP Growth, PPP Basis Source: IMF USA Other Advanced Economies China Rest of the World 1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-04 2005-09 100% 80% 60% 40% 20% 0% ContributionPercentage
- 18. 18 International Investing:An Independent Advisor’s Guide Key Emerging Economies The BRICs Of the emerging markets, the global focus has been on Brazil, Russia, India and China, also known as the BRIC economies. This was a phrase coined by Goldman Sachs in 2002 to refer to the nations that it highlighted as most likely to become forces in the global economy. A combination of a large population, a shift to a more capitalist orientation and access to natural resources has fostered the rapid growth in BRIC countries, making them economically attractive and thus an area of high attention. There remain other countries that are exhibiting rapid growth, such as Poland, South Africa and Oman, though they do not yet currently possess the combination of factors described above. Most of the BRIC countries have rebounded rapidly during the start of 2009. 80% 60% 40% 20% 0% -20% -40% -60% -80% -100% ContributionPercentage Exhibit 17: Emerging Markets With the Most Significant Moves in 2008 and 2009 Russia India Turkey Hungary Brazil Russia Chile Indonesia Brazil India Countries with Biggest Declines in 2008 Countries with Strongest Recoveries in the First Half of 2009 Source: An Update on Emerging Markets, MSCI Barra Research, September 2009 Exhibit 18: Economic Forecasts Diverge Over the Next Two Years Source: IMF Forecasts (2008) for 2009-1010 8% 6% 4% 2% 0% -2% -4% -6% ForecastGDPGrowth (Average2009-1010Change) Brazil China India Russia France Germany Hong Kong Singapore U.K. U.S. Moreover, BRIC countries are shown to have stronger and more positive GDP growth predictions than some developed countries. By 2040, the BRIC countries are forecasted to overtake the G7 nations in terms of GDP. As these economies grow, domestic wealth is created at a fast pace. For example, over the next ten years the growth in the middle classes of these countries is expected to be 400%. Within the next five years, there will be more high-net-worth individuals in China and India than in the United Kingdom. By 2025, Russia is expected to have a higher GDP per capita than the United Kingdom.
- 19. International Investing: AnIndependent Advisor’s Guide 19 Exhibit 19: Real GDP Growth BRIC Versus United States Source: IMF, October 2009 15% 12% 9% 6% 3% 0% -3% -6% -9% -12% -15% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2008 2007 PercentageofGrowth China India Russia Brazil United States As demonstrated in Exhibit 19, the rate of GDP growth in the United States has decreased or remained relatively stable, whereas the rate of GDP growth by BRIC countries has shown a higher increase year over year. Exhibit 20 illustrates the projected real GDP growth rate from 2015 to 2020 for BRIC countries compared to the United States. The BRIC average growth rate is 4.6%, which is more than double the projected U.S. growth rate over five years. Exhibit 20: Projected Real GDP Growth BRIC Versus United States 2015-2020 Source: IMF India China Brazil Russia U.S. 6% 5% 4% 3% 2% 1% 0% AveragePercentageYearoverYear BRIC Average 4.6% U.S. 2.1%
- 20. 20 International Investing:An Independent Advisor’s Guide Even with growth in the BRIC countries, it is likely that the United States will remain the dominant economy for the foreseeable future. The population base of the United States is only third in size behind China and India, and its economy and financial markets remain the largest in the world. However, India and China specifically have demonstrated consistent high growth in GDP and in GDP per capita. China will likely become the second largest economy by 2020. Exhibit 21: Population and Wealth Comparison Source: IMF October 2009 Emerging MarketsDeveloped Markets Frontier Markets 2009 Population (Million) Size of Bubble Represents GDP (Measured in USD with Current Exchange Rate 2009) Russia Brazil Germany United States Japan India China 140012001000800600400200-200 0 25% 20% 15% 10% 5% 0% -5% Argentina U.K. GDPGrowthRate Accessing International Opportunities Non-institutional investors now have an increasing range of investment options in international markets, enabling them to capitalize on opportunities historically limited to institutional investors. The two main approaches can be categorized at a high level as direct and indirect investing. Indirect investing via pooled funds, including mutual funds, and ETFs allows investors to gain exposure primarily to the equity capital markets of developed and emerging markets. Direct investing into international markets includes investing in tradable instruments on local stock exchanges or over the counter through a broker-dealer.
- 21. International Investing: AnIndependent Advisor’s Guide 21 U.S. investor demand for foreign stocks and bonds has increased during the past several years, and pooled funds have been one of the primary means for investing abroad because they provide an economical way of accessing these markets. In 2007, U.S. residents purchased $252 billion in foreign stocks and bonds, and mutual funds and ETFs accounted for most of those purchases (Exhibit 22). Exhibit 22: Growth in Purchases in Foreign Securities by United States Investors Source: Fact Book 2008, Investment Company Institute Mutual Funds ETFs Non-Fund 2003 2004 2005 2006 2007 200 150 100 50 0 Billions($) Indirect Investment Pooled Funds Mutual funds fall into two major categories: index and active. Index mutual funds are typically constructed to simply mirror an investment index such as the S&P 500 or MSCI EAFE. These are usually referred to as passive investment vehicles as the underlying stocks in the portfolio are only changed when there are changes to the underlying constituent stocks in the index. Actively managed mutual funds are funds that are actively traded according to the investment strategy of the portfolio manager, and stocks in the portfolio are actively traded as needed to meet investment objectives. ETFs are similar to index mutual funds in that they are constructed to mirror indices, but they are listed on stock exchanges and so are tradable intraday, as opposed to mutual funds, which are only bought and sold at end-of-day prices.
- 22. 22 International Investing:An Independent Advisor’s Guide Exhibit 23 demonstrates the overall growth of international pooled funds in the U.S. in terms of the number of launches of actively managed funds, index funds and ETFs. After a lull in the growth rate during the 1990s, 2005 saw a significant increase in the number of new fund launches, catering to an increasing appetite for international investment. Exhibit 23: Number of International Fund and ETF Launches per Year Source: Morningstar Research Active Index ETF 150 120 90 60 30 0 NumberofLaunches 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2008 2007 1953 1954 1956 1962 1959 1970 1973 1974 1976 1978 1979 1980 1981 1982 1984 1985 1986 1987 1988 1989 1990 1001 1992 1983 Among the three types of international funds, active funds (managed by portfolio managers based on views of anticipated favorable business conditions in an industry or interest rate movements affecting a specific asset class) are the largest, with total assets under management (AUM) of approximately $974 billion. ETFs are approximately $200 billion and index funds are approximately $118 billion. In terms of the numbers of funds, there are approximately 829 actively managed funds, 153 ETFs and 56 index funds. Exhibit 24: Distribution of Pooled Funds by Type Source: Morningstar Research Number and Percentage of Funds by Fund Type (Total = 1038) AUM and AUM Percentage of Funds by Fund Type (Total = $1.3 trillion) Index 56, 5% ETF 153, 15% Active 829, 75% Index $118 billion, 10% ETF $200 billion, 15% Active $974 billion, 75%
- 23. International Investing: AnIndependent Advisor’s Guide 23 Index Mutual Funds Currently, index funds represent the smallest international opportunity set; only approximately 42 funds with less than $100 billion in AUM are available for investment.5 As the chart below shows, 76% of the funds are focused on developed markets, primarily international large-cap stocks. Offerings for emerging markets funds exist, but a review of the underlying holdings shows that they have more than 25% of their assets in non- emerging markets, and so they represent a blend of developed and emerging assets. Developed $89.5 billion, 76% Exhibit 25: Distribution of AUM by Type of International Index Mutual Fund AUM and Percentage of Index Funds by Fund Type (Total = $118 Billion) Source: Morningstar Research Developed/Emerging Blend $1.4 billion, 1% Global $26.8 billion, 23% Expense ratios for these funds range from 3 to 300 basis points, with an average of approximately 84 basis points. Fees for the top ten funds, however, range from 3 to 112 basis points, with an average of 29 basis points. ETFs ETFs were initially developed as an alternative to index mutual funds, which investors can only buy and sell once per day after the underlying assets have been priced at the end of the trading session. Similar to index mutual funds, ETFs typically track a stock index, but are listed on exchanges, and so they can be traded on an intra-day basis like a stock. Since their inception, the market for ETFs has grown tremendously. ETFs provide investors with the flexibility to make more precise asset allocation decisions than index funds, typically with lower expense ratios. 5 Source: Morningstar Research. See Appendix for a detailed description of the fund categorizatoin methodology for this section.
- 24. 24 International Investing:An Independent Advisor’s Guide Currently, there are over 150 funds with total AUM of approximately $200 billion (Exhibit 26). ETFs are available for specific country and regional indices in both the developed and emerging sectors, giving an investor the ability to pursue a global strategy in a number of different markets. Developed $89.5 billion, 45% Exhibit 26: Distribution of AUM by ETF Type AUM and Percentage of ETF Funds by Fund Type (Total = $200 Billion) Source: Morningstar Research Developed/Emerging Blend $19.5 billion, 10%Global $3.8 billion, 2% Emerging $86.6 billion, 43% In 2008, the slower growth of ETF assets reflected the overall market movement, but there is still evidence for future growth according to the overall trend in Exhibit 27. Although the ETF net asset share of international ETFs grew only at a rate of 22% in 2008, these shares have increased from 3% to 30% between 2000 and 2007, supporting the view that investors are looking more favorably upon diversifying their portfolios through indirect investments in the international markets via ETFs. Whereas many other investment vehicles, such as hedge funds and mutual funds, faced net outflows in 2008, ETFs grew at a steady rate with a net inflow of approximately $177 billion. Investor interest in global and international ETFs continues to remain strong and, according to the Investment Company Institute (ICI), between 2004 and 2008, international and global ETFs issued approximately $142 billion net in new shares. Expense ratios for developed ETFs range from 23 to 108 basis points; for emerging ETFs, from 16 to 98 basis points. The overall average is around 57 basis points. Expense ratios for the top ten developed ETFs range from 11 to 52 basis points, and for the top ten emerging ETFs, from 20 to 72 basis points. Exhibit 27: Growth in International Investing Through ETFs Source: Investment Company Institute % Other ETF % Global/International ETF Years 100% 80% 60% 40% 20% 0% 1996 200820072006200520042003200220012000199919981997
- 25. International Investing: AnIndependent Advisor’s Guide 25 Actively Managed Mutual Funds Actively managed funds have the longest track record in international investing, with the first fund launched in 1953 by DWS, followed by Templeton in 1954. Currently, there are approximately 829 funds with approximately $974 billion in AUM. Exhibit 28: Distribution of AUM by Type of Actively Managed Mutual Funds AUM and Percentage of Active Funds by Fund Style (Total = $974 Billion) Source: Morningstar Research Developed $510.4 billion, 52% Developed/Emerging Blend $286.6 billion, 29% Global $158.9 billion, 16% Emerging $17.8 billion, 2% In terms of the breadth of choice, funds in developed markets offer a much wider range based on regions, countries, styles (value versus growth) and industry sectors. While many are labeled “emerging,” a review of their underlying holdings indicates a blend of developed and emerging assets. For actively managed international funds, the expense ratio had a relatively broad range, from 18 basis points to over 330 basis points, with an average of 133. Indeed, expense ratios for the top ten funds range from 47 to 128 basis points, highlighting the need for an investor to carefully balance any perceived potential upside with associated costs. Summary Both international ETF and international mutual fund instruments can provide the required exposure to take advantage of potential growth and diversification opportunities, though there are factors relevant to each instrument that should be considered. Exhibit 29 highlights the key attributes of both ETFs and mutual funds as they pertain to investment costs and investor control, as well as showing which investor profiles might be best suited to each strategy.
- 26. 26 International Investing:An Independent Advisor’s Guide Exhibit 29: Summary Assessment of International ETF and Mutual Fund Options Investment Option Fees Customization Control Recommended Investor Profile International ETFs – Lower fees as ETFs are traded as stock – More tax effective since ETFs do not constantly buy and sell shares and capital gains tax is minimized – No back-end fees or penalties incurred on redemptions – No control of underlying stock or bond portfolio – Variety of international ETFs, including broad- based and regional ETFs, single-country, developed markets, emerging markets and global sector ETFs – No rebalancing option – No active management – Shorter investment horizon – Interest in short-term trading – Desire for higher liquidity – Desire for greater diversification and potentially higher returns – Low interest in following the markets and managing portfolios – Infrequent trading, whereas frequent trading may result in high transaction costs and tax liability – Smaller initial investments, and no minimum investments on most ETFs – Taxable accounts benefit from tax advantages of ETFs – More complex trading techniques for savvy investors, such as short sales and stop loss and limit orders International Mutual Funds – Relatively higher fees, for example load fees – Foreign taxes – Sales charges, annual fees and other expenses – Wide choice of mutual fund types, including international, regional, country and global sector funds – Limited ability to weight industry segments – Dollar cost averaging possible – Automatic dividend reinvestment possible – No control over capital gains tax – No control over dividend cycles – Longer investment horizon – Desire for more active management of funds – Desire for greater diversification and potentially higher returns – Desire to regularly invest small amounts and lower trading costs involved – Smaller investors with limited funds seeking to avoid commission fees – More frequent traders and fewer transaction fees assessed Costs ETFs are generally less expensive than index and actively managed mutual funds, particularly in international investments. Unlike mutual funds, they also do not require a minimum investment. However, investing in markets that are potentially more volatile has been more problematic for ETFs than active mutual funds, as they do not have the ability to select and rebalance investments in times of crisis. Actively managed mutual funds have the highest expense ratios due to the additional costs incurred in evaluating overseas companies. Mutual funds typically charge front-end or back-end loads on top of the management fees. Some international mutual funds also impose a two-month redemption fee on sales in an attempt to reduce short-term arbitrage trading, which might seek to take advantage of time zone differentials in opening and closing price levels. Tax-managed funds also may impose redemption fees as a means of discouraging shareholder turnover. Typically, however, back-end fees or penalties are not assessed on redemptions in ETFs.
- 27. International Investing: AnIndependent Advisor’s Guide 27 Exhibit 30: Fees on Pooled Funds by Region Fees for International Pooled Funds—Lows and Highs by Fund Style Source: Morningstar Research Active ETF Index Developing/Emerging HighLow HighLow Developed HighLow Global HighLow Emerging BasisPpoints 0 50 100 150 200 250 300 350 Flexibility ETFs provide investors the opportunity to exploit daily short-term movements in the market by allowing intraday trading, and to take advantage of newly established trends. Investors in mutual funds are restricted to trading once a day. One benefit that mutual funds seem to have over ETFs is the flexibility of dollar cost averaging. It might be more costly to trade frequently in ETFs, as a commission is charged for each transaction. ETFs and mutual funds can also differ in the treatment of dividends. While mutual funds give investors the flexibility to automatically reinvest dividends, investors in ETFs must explicitly control how dividends are handled. A decision to reinvest dividends may result in transaction fees, though some brokers allow reinvestment of dividends at no additional cost. In addition, some older ETFs are structured as unit investment trusts (UITs). The delay in reinvesting dividends in UITs can have a negative effect on total returns. In UITs, dividends are held in an interest-bearing account until the end of each quarter before being reinvested. In contrast, a mutual fund may reinvest dividends daily. Risks Unlike mutual funds, ETFs are traded on stock exchanges. The intraday pricing characteristic of ETFs results in transactions that are priced at market value, rather than end-of-day net asset value (NAV). This can work in favor of the investor when the ETF is bought at a discount to the underlying securities, but may adversely impact the investor when bought at a premium. In thinly traded, volatile markets, the bid or ask spread of an ETF may widen, which may result in investors buying at a premium to the portfolio’s value, or conversely, selling at a discount. Transactions in mutual funds, however, are priced once a day at the fund’s closing price, which prevents investors from taking advantage of intraday price movements.
- 28. 28 International Investing:An Independent Advisor’s Guide The positions held by ETFs are more transparent as they always align with major indices. This makes asset allocation across an investor’s entire portfolio easier to achieve as all the underlying instruments are known. A mutual fund might only release its holdings on a quarterly basis or less frequently, making it difficult to ascertain the underlying securities and the exposure to each. Unlike actively managed mutual funds, ETFs that track a particular underlying market segment may allow investors to execute a strategy more effectively as these investment vehicles remain true to their stated objectives. Depository Receipts Investors have the option of investing directly in the shares of a foreign company (as opposed to using a pooled fund) in U.S. dollars and using U.S. standard settlement processes via the use of depository receipts (DRs). DRs are negotiable certificates issued by a U.S. bank representing shares of a foreign stock, with the price of the DR relating directly to the price of the foreign stock in its home market. The issuing broker manages both the tracking to the local share price and any currency movements, for which a fee is charged. DRs are transacted in the same way as domestic securities in terms of clearance, settlement, transfer and ownership. As Exhibit 31 shows, a significant number of companies from developed, emerging and frontier countries have used this method to raise capital and develop a liquid market for their shares in the United States. The majority of them are large-cap firms, with some mid-cap companies also taking advantage of the DR market to access capital. Exhibit 31: Depositary Receipts by Country Classification Total = 3,110 Source: BNY Mellon, 2009 Emerging 1,482, 48% Developed 1,482, 48% Fledgling 52, 2% Frontier 141, 5% The demand for international investing has been driving growth in the DR market with total investments in DRs totaling more than $1.2 trillion in March 2008, a 36% increase from 2007. Exhibit 32 shows the increase in DR trading volume as a whole, with a record $4.4 trillion in trading volume in 2008. DR issuers from BRIC countries dominated the market, accounting for over 50% of the trading volume.
- 29. International Investing: AnIndependent Advisor’s Guide 29 Exhibit 32: Growth in Annual Depository Receipt Trading Volume Source: BNY Mellon 1999 200220012001 2003 2004 2005 2006 2007 2008 5,000 4,000 3,000 2,000 1,000 0 TradingVolume(Billions$) The ability to invest in a foreign company as in a domestic company enables DR investors to avoid the costs and risks of investing directly in local markets. Currency fluctuations, costs for local custodian settlement, safekeeping charges and foreign taxes on transactions are eliminated. Dividends are also paid in U.S. dollars, providing a greater level of transparency to these transactions. There are different types of DRs. Some are unlisted and trade as over-the-counter stocks, while others are listed on the New York Stock Exchange (NYSE) or NASDAQ and so are registered with the U.S. Securities and Exchange Commission (SEC) and required to adhere to GAAP accounting and reporting principles. Lastly, for institutional investors, Rule 144A6 and Regulation S7 securities are available. These typically private placements are reserved for qualified institutional buyers (QIBs), who are described as sophisticated investors who understand the risks of investing in these instruments. Fees for investing in DRs are limited to the fees charged by the issuing broker to either perform the initial conversion or to simply buy the DR shares from another existing investor. Typically, once there is a liquid market, about 95% of trading is done between investors, rather than issuing new shares. Standard domestic custody and safekeeping fees also apply. Building an internationally diverse portfolio from DRs would require an evaluation of the intended investment strategy and the required cost and effort compared to simply investing in a pooled fund. Direct Investment Investing via mutual funds, ETFs and DRs allows investors to gain exposure primarily to the equity capital markets of developed and emerging markets, whereas direct investing via the purchase of tradable instruments on local stock exchanges offers investors a greater number of options. All the international markets in the MSCI Developed Markets and MSCI Emerging Markets indices have existing stock exchanges and most allow foreign investors to purchase securities and deal locally on those exchanges. 6 Rule 144a is an SEC rule that modifies a two-year holding period requirement on privately placed securities to allow institutional buyers to trade those positions among themselves, substantially increasing the liquidity of the related securities. 7 Regulation S has been amended to bring its concepts more in line with Rule 144, with the objective of reducing fradulent practices in offshore offerings of equity securities.
- 30. 30 International Investing:An Independent Advisor’s Guide Direct Investing in Developed Markets Other than the United States, the Japanese and European capital markets are the most developed in the world. Many developed countries have more than one stock exchange and offer numerous tradable instruments, including equities, warrants, options, bonds, derivatives, unit trusts, commodities, rights, indices, futures and debentures. Exhibit 33 below shows a partial listing of stock exchanges, along with some of the risks and country-specific rules and regulations that investors should consider. Exhibit 33: Developed Countries Direct Investment Country Exchange Type Exchange Name Details/Comments France Primary Stock Euronext (Does not include NYSE Euronext) Tax – Investors pay a flat 16% capital gains tax – Dividends paid to non-residents are subject to a 25% withholdings tax Ease of entry – According to the U.S. State Department, the formal French investment regime remains the least restrictive in the world United Kingdom Primary Stock London Stock Exchange Tax – A 20% withholding tax applies to dividends paid to foreigners by REITs – Interest income paid Ease of entry – The United Kingdom does not discriminate between UK nationals and foreign investors except in a few exceptional circumstances Futures/Options/ Derivatives EDX London ICE Futures Europe The Baltic Exchange London Metals Exchange Germany Primary Stock Deutsche Börse AG Tax – All dividends distributed to foreign investors (non- residents) are also subject to the flat withholding tax of 25% Ease of entry – German law offers foreign investors national treatment Futures/Options/ Derivatives RMX Hannover Commodities European Energy Exchange Japan Primary Stock Osaka Stock Exchange Tax – Dividends distributed to foreign investors are subject to a withholding tax of 20% – Interest distributed to foreigners is subject to a withholding tax of 20% – Investors are taxed on gains from the sale of shares at 20% (however, through December 2008, this rate is 10%) Ease of entry – Japan maintains no formal restrictions on inward portfolio investment Tokyo Stock Exchange Futures/Options/ Derivatives Kansai Commodities Exchange Tokyo Commodity Exchange Tokyo Financial Exchange Futures/Options/ Derivatives/ Commodities Central Japan Commodity Exchange Canada Primary Stock/ Futures/ Options/Derivatives/ Commodities TSX Group Tax – Dividends paid to foreign investors are subject to a 25% tax – Interest paid to non-residents is subject to a 25% tax Ease of entry – Canada offers full national treatment to foreign investors
- 31. International Investing: AnIndependent Advisor’s Guide 31 Direct Investing in the BRIC Markets The BRIC countries offer equities, derivatives, commodities and other instruments to local investors. Many of these instruments are not available via mutual funds or ETFs. As Exhibit 34 illustrates, there is significant liquidity, but also some country-specific risks. Exhibit 34: BRIC Countries Direct Investment Country Exchange Type Exchange Name Details/Comments Brazil Primary Stock/ Futures/ Options/Derivatives BMF Bovespa (On May 8, 2008, the Brazil Mercantile Futures Exchange merged with the São Paulo exchange to create the BMF Bovespa exchange) Tax – Investors pay 15% capital gains tax – Interest paid to foreign investors is subject to a 15% tax Ease of entry – Foreign investors are required to maintain a presence or appoint a representative broker or institution – The past closure of stock exchanges due to market volatility raises questions on liquidity risk Russia Primary Stock RTS Stock Exchange Tax – Foreign investors pay a 30% capital gains tax and a 15% income tax on dividends – Foreign investors pay a 20% tax on interest income – A 13% tax is levied on the sale of shares – The past closure of stock exchanges due to market volatility raises questions on liquidity risks Ease of entry – Investing in Russia is difficult for foreign investors due to the lax and shifting regulatory environment. Laws and regulations are often murky – A new law passed in March 2008 limits foreign investments in certain industries deemed to be of strategic significance by Russia’s parliament Moscow Interbank Currency Exchange India Primary Stock Bombay Stock Exchange Tax – Foreign investors pay a 30% short-term capital gains tax and a 10% long-term capital gains tax – A 10% tax rate is levied on interest income received Ease of entry – Foreign investors investing in India must register with the Securities and Exchange Board of India (SEBI) – India has caps in place on the quantity of shares foreigners can own and these vary by sector and type of investing instrument National Stock Exchange Commodities Multi Commodity Exchange China Primary Stock Shanghai Stock Exchange Tax – There are no capital gains taxes – A 10% witholding tax is levied on dividend income for foreign investors – Foreigners pay a 10% tax on interest income received— however, for residents of Hong Kong this is reduced to 7% Ease of entry – A changing regulatory environment can prove to be challenging for foreign investors – A limit on foreign investors purchase of locally traded instruments is strictly enforced using a quota system Shenzhen Stock Exchange Futures/Options/ Derivatives Chinese Gold and Silver Exchange Dalian Commodity Exchange Zhengzhou Commodity Exchange Shanghai Futures Exchange
- 32. 32 International Investing:An Independent Advisor’s Guide Direct Investing in Other Emerging Markets With an improved investment climate, international investors are increasingly becoming interested in other emerging markets that are showing positive GDP growth. Exhibit 35 shows a selection of these countries. Although they have less liquidity than the BRIC countries, these developing markets offer foreign investors opportunities to invest locally in stock markets and, in some cases, in derivatives and futures instruments. Exhibit 35: Non-BRIC Emerging Countries Stock Exchanges Country Exchange Type Exchange Name Details/Comments Mexico Primary Stock Bolsa Mexicana de Valores Tax – Interest paid to foreigners is subject to a withholding tax rate of 4.9% – There are no dividend taxes Ease of entry – Mexico is open to foreign direct investment (FDI) in most economic sectors and has consistently been one of the largest recipients of FDI among emerging markets Futures/Options/ Derivatives Mexican Derivatives Exchange Turkey Primary Stock Istanbul Stock Exchange Tax – Dividends paid to non-residents are subject to 15% withholding tax – A 10% interest income tax is assessed on foreign investors – Capital gains derived from the sale of securities are subject to income taxes subject to a detailed schedule of holding periods Ease of entry – According to the U.S. State Department, Turkey has one of the most liberal legal regimes for investment in the OECD – However an excessive bureaucracy, a slow judicial system, high taxes lead to a highly inefficient legal and regulatory environment Commodities Istanbul Gold Exchange Malaysia Primary Stock Bursa Malaysia Tax – No taxes are assessed on dividend income – A withholding tax of 15% applied to non-residents on all interest income – There are no capital gains taxes Ease of entry – According to a World Bank survey Malaysia ranks third in protecting investors—both local and foreign – Malaysia limits foreign investors’ participation in the financial services sector Futures/Options/ Derivatives Bursa Malaysia Derivatives Chile Primary Stock Bolsa de Comercio de Santiago Tax – All interest is subject to a 35% holding tax Ease of entry – Credit is allocated on market terms and is available to foreigners, although the Central Bank does reserve the right to restrict foreign investors’ access to internal credit if a credit shortage exists
- 33. International Investing: AnIndependent Advisor’s Guide 33 Costs Costs for investing usually include brokerage commission and custodian fees for the settlement and safekeeping of assets in local markets. Portfolio accounting and administration costs are typically charged by custodians. Costs vary among markets and providers. Institutions frequently use a sliding scale arrangement in which costs decline as assets or trade volume increase. For an international institutional investor, four major types of fees are charged when investing locally. AUM or portfolio-based fees are typically charged in basis points: 1. Asset safekeeping charges 2. Portfolio accounting and administration charges Transaction fees are charged per trade, which can be charged either as a straight fee or in basis points: 3. Brokerage commissions 4. Settlement transaction charges Asset safekeeping charges vary widely among countries. These charges are typically the lowest in the United States, where fees are usually under 1 basis point per annum. Safekeeping fees in Europe are typically higher due to the fragmented nature and complexity of the post-trade infrastructure in the region. Fees in emerging and frontier countries are even higher, in some cases over 50 basis points. So for a $1 billion portfolio, charges for a U.S.-only portfolio could be under $100,000 per year or they could be over $5 million for a portfolio that is 100% allocated to emerging and frontier assets. Charges for portfolio or fund accounting and administration are usually much more standardized, regardless of the asset type in the portfolio. These typically range from 2 to 10 basis points, depending on the amount of services required. With brokerage commissions, the United States is the least expensive, while international commissions are substantially higher. Elkins-McSherry, a transaction cost analysis provider, estimates average costs for U.S. trades at 8.46 basis points, 18.30 basis points for European Union trades and a global average of 22 basis points. These costs include commissions plus local taxes and fees. Settlement transaction fees are also market specific, with the developed markets significantly less expensive than emerging or frontier markets. Flexibility For international investors considering direct investing, a cost/benefit analysis should be undertaken to determine whether direct investing is economically viable, or whether investment in pooled funds or DRs would be more effective. A direct investing approach provides greater flexibility in an investment portfolio, as well as access to a greater range of international instruments than those covered by mutual funds and ETFs, which tend to be heavily weighted towards equities. Direct investing requires the investor to leverage service providers for international access to both developed and emerging global markets.
- 34. 34 International Investing:An Independent Advisor’s Guide Risks The increase in the number of local tradable assets is counterbalanced by the risk of direct investing. For example, investors in foreign markets are subject to local laws and regulations regarding capital adequacy, tax payment and profits repatriation. In addition to these regulatory challenges, foreign investors must also manage potentially adverse foreign exchange and local interest rate risks for fixed income investments. While these risks bear an upside potential, they could also significantly harm foreign investors if mismanaged. A number of developed and emerging markets have treaties with one another to prevent double taxation of their citizens who may be investing abroad. These treaties vary by country, investor class and tax type. Direct foreign investors should be familiar with tax treaties of countries in which they intend to invest as the tax relief they receive could boost their investment returns. A direct investor in international markets, particularly in emerging market countries, may see potentially greater returns, but could also face a range of risk profiles that do not exist in most developed markets. The inability to buy or sell based on investor preference, such as liquidity risk, is a key consideration. Liquidity risks are significantly higher in emerging markets predominantly due to the relative immaturity of these capital markets. In addition, there can be more restrictions on order types. For example, the short selling of securities in China is prohibited, which would inhibit the execution of some investing strategies. Also, the lack of robust derivatives markets in emerging markets may hamper investors who want to hedge their investments locally. However, this situation is changing. For example, the combination of Brazil’s futures and equities exchanges—the BMF and Bovespa merger in May 2008—should significantly improve the synergies and volumes of the futures, options, derivatives and equity markets in Brazil. Both local and foreign investors will be able to access most markets on the same platform and exchange, and the expected increase in trading volume will help reduce the liquidity risk of the Brazilian capital markets. Getting Started International investing carries risks that are unique to international markets, necessitating an evaluation of areas such as currency, liquidity and political and economic risks. A service provider helps to mitigate these risks by providing critical research and specialist support in managing these areas. Risks Related to International Investing Investors must consider a number of risks before constructing an international portfolio. Risks are dictated, in part, by the geographical scope of the investment: a broad international portfolio; a more limited portfolio focused on either emerging markets or developed markets; and a portfolio focused on a specific region, such as Europe or Latin America, or a specific country or countries. The profile of the international portfolio informs the risk evaluation. Currency Risk—Foreign investment returns depend on both the local currency exchange rate value against the U.S. dollar and the stock price of the local currency. Liquidity Risk—The typically lower trading volumes in international markets, as compared to the United States, and the fact that a number of developing countries allow foreign investors to purchase only a limited quantity of specified classes of securities, reduce the liquidity of these markets.
- 35. International Investing: AnIndependent Advisor’s Guide 35 Political and Economic Risk—Political events have the potential to destabilize returns from foreign markets. Particularly in emerging markets, macroeconomic conditions remain relatively volatile with historical policy changes such as currency controls, taxation changes and trade restrictions negatively affecting foreign investors. In addition to these fundamental risk considerations, investors must also consider informational issues. Obtaining financial information on specific foreign companies may be problematic since accounting and financial disclosure practices can vary widely from U.S. standards. Leveraging Pershing for Direct Investment Investing directly in foreign markets via the purchase of tradable instruments on local stock exchanges typically requires a relationship with a local broker-dealer. Pershing offers efficient access to a breadth of local brokers in various international markets, and investors can leverage these relationships when trading. Leveraging Pershing for Direct Investment Sophisticated services: Direct access Preliminary services: Indirect access No International access InternationalCapabilities Pershing Other major service providers Regional players Maturity Pershing is a leader in the direct investment market and provides a complete suite of services: Global execution capabilities for equities, fixed income and derivatives Multicurrency support, thus offering execution capabilities in non-U.S. dollars along with foreign exchange solutions Global custodian capabilities with connectivity to various industry utilities and international depositories Transparent and flexible reporting with multicurrency statements International algorithmic trading (including TWAP, VWAP, implementation shortfall and percentage of volume) Dedicated support 24 hours a day, 6 days a week, with a single point of contact International access through American Depositary Receipts (ADRs) Pershing also provides a robust technology infrastructure, which includes straight-through-processing capabilities (in markets where permissible), and seamless integration capabilities with various third-party solutions and applications.
- 36. 36 International Investing:An Independent Advisor’s Guide One-Stop Shop Pershing gives independent advisors a competitive edge in meeting growing investor demand for international portfolio diversification. Pershing can help you manage the additional complexities and risks related to international investing with a true one-stop shop. Pershing offers a complete range of trading, operational support and diverse investment options across different geographical regions and provide local market knowledge and expertise around potentially complex regulations and legal challenges including risk management. In addition, Pershing provides a consultative relationship by offering education and support for dynamic regulations such as alterations in the access of different types of vehicles and changes in the investment landscape, especially in the emerging economies. A partnership with Pershing provides registered investment advisors (RIAs) with more transparency into the international investment process. RIAs who identify investment opportunities early and redirect investments appropriately will benefit from Pershing’s extensive capabilities and support. Movement from Global Investment Banks Pershing meets the needs of independent firms who increasingly desire pure-play custody and brokerage services. These firms look to providers who have a strong balance sheet and are less exposed to the effects of the credit crisis. This era of financial transformation creates a unique opportunity to form stronger strategic partnerships. By not directly competing with an investment firm’s business and by not taking positions in the firm’s transactions, Pershing offers a relatively low-risk and high-reward proposition, thus ensuring reliability and safety for the investment firm. When evaluating a provider, consider Pershing’s comprehensive services and robust infrastructure. Add to those Pershing’s strong industry reputation, leading track record and a growing customer base, and you will find Pershing a natural choice as your firm’s strategic partner for international investments.
- 37. International Investing: AnIndependent Advisor’s Guide 37 Appendices MSCI Market Definitions Criteria Frontier Emerging Developed A. Economic Development A.1 Sustainability of economic development No requirement No requirement Country GNI per capita 25% above the World Bank high income threshold* for 3 consecutive years B. Size and Liquidity Requirements B.1 Number of companies meeting the following standard index criteria 2 3 5 Company size (full market cap)** USD 434 mm USD 857 mm USD 1,734 mm Security size (float market cap)** USD 34 mm USD 434 mm USD 857 mm Security liquidity 2.5% ATVR*** 15% ATVR 20% ATVR C. Market Accessibility Criteria C.1 Openness to foreign ownership At least some Significant Very high C.2 Ease of capital inflows/outflows At least partial Significant Very high C.3 Efficiency of the operational framework Modest Good and tested Very high C.4 Stability of institutional framework Modest Modest Very high * High income threshold for 2007: GNI per capita of USD 11,456 (World Bank, Atals method). ** Minimum in use for the May 2008 Semi-Annual Index Reviews, updated on a semi-annual basis. *** Annual Traded Value Ratio (ATVR) Methodology Description of the methodologies used to develop analytical charts. Section 2 Footnote 1: In addition to stock exchanges, there has also been high growth in the number of fixed income and derivatives exchanges. For the purposes of this study, fixed income and derivatives-only exchanges were excluded. Many of the stock exchanges included in this study listed and traded multiple instrument types, but all traded common shares at a minimum. Exhibit 3: Comparison of Returns in Equities and Bonds Across Different Regions, 2003–2009 Equity indices – MSCI – Return is a six-year compounded return. Bond indices – Citi (Solomon) – Return is a six-year compounded return. EM includes BRIC and other EM Asian countries, Latin America and Eastern Europe. Sharpe ratio is calculated using a five-year compounded return and a 2% risk-free rate. Monthly indices used to derive the return, standard deviation and correlations include the following: – MSCI All World index used as a proxy for all world equities – MSCI USA Standard Core index used as a proxy for U.S. equities – MSCI EM Standard Core index used as a proxy for emerging markets equities
- 38. 38 International Investing:An Independent Advisor’s Guide – MSCI World, excluding U.S. Standard Core index, used as a proxy for world (excluding U.S.) equities – Citigroup World Broad Investment Grade index used as a proxy for all world bonds – Citigroup U.S. Broad Investment Grade index used as a proxy for U.S. bonds – Citigroup Europe Broad Investment Grade index used as a proxy for world (excluding U.S.) bonds – Citigroup Emerging Markets Broad Investment index used as a proxy for emerging markets bonds Exhibit 4: Returns of U.S. and International Portfolios All returns are compounded annualized returns for October 2003 to September 2009, and all standard deviations are annualized from monthly standard deviations. Portfolio 1: U.S.-only portfolio represents a U.S. balanced portfolio with weights in U.S. equities at 60% and bonds at 40%. Portfolio 2: U.S. and emerging market portfolio represents a balanced portfolio with emerging markets investments both in equities and bonds (U.S. equities at 48%, U.S. bonds at 32%, EM equities at 12% and EM bonds at 8%). Monthly indices that were used to derive the return, standard deviation and correlations include the following: – MSCI All World Index used as a proxy for all world equities – MSCI USA Standard Core index used as proxy for U.S. equities – MSCI EM Standard Core index used as a proxy for emerging markets equities – MSCI World (excluding U.S. Standard Core index) used as a proxy for World (excluding U.S.) equities – Citigroup World Broad Investment Grade index used as a proxy for all world bonds – Citigroup U.S. Broad Investment Grade index used as a proxy for U.S. bonds – Citigroup Europe Broad Investment Grade index used as a proxy for world (excluding U.S.) bonds – Citigroup Emerging Markets Broad Investment index used as a proxy for emerging markets bonds Section 3 The data on funds and ETFs was extracted from Morningstar’s website database on October 7, 2009. For international index funds, the criteria includes the following: – Percentage of non-U.S. stock greater than 50 – Either index or enhanced index funds – Total assets greater than or equal to $1 million – A distinct portfolio For international active funds, the criteria includes the following: – Percentage of non-U.S. stock greater than 50 – No index or enhanced index funds – Total assets greater than or equal to $1 million – A distinct portfolio
- 39. International Investing: AnIndependent Advisor’s Guide 39 From that point, the following scheme was followed to categorize the vehicles for the charts in the paper. Fund/ETF Category U.S. (Asset%) International Developed (Asset%) Emerging (Asset%) Global 25% 0–75% 0–75% International Developed 0–25% 75% 0–25% International Emerging 0–25% 0–25% 75% International Developed/Emerging Blend 0–25% 0–74% 0–74% For those vehicles with no data on holdings available (approximately 20%), the Morningstar category and fund name were used as proxies and categorized accordingly.
- 40. 40 International Investing:An Independent Advisor’s Guide Pershing Advisor Solutions LLC, a subsidiary of The Bank of New York Mellon Corporation, member FINRA, SIPC. Clearing, custody or other brokerage services may be provided by Pershing LLC, member FINRA, NYSE, SIPC. Pershing Advisor Solutions relies on its affiliate Pershing to provide execution services. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. This guidebook is part of a program designed to help registered investment advisors and financial services firms identify trends, enhance operations and grow revenue. It represents Pershing Advisor Solutions’ unique approach to practice management support—going beyond high-level guidance to offer actionable information, personalized consulting and ready-to-execute programs. To learn more about Pershing Advisor Solutions, visit us on the web at www.pershingadvisorsolutions.com. About the Authors Thomas Roughan Thomas Roughan is a Partner at Capco in the Capital Markets practice with over 20 years experience in financial services and consulting. He has led numerous business strategy, operational performance improvement, risk and control and IT assessment engagements. His client base has included broker dealers, investment managers, wealth managers, custodian banks, clearing firms, stock exchanges and depositories. Prior to joining Capco, Tom worked for Ernst Young Management Consulting in their Financial Services practice and with State Street Bank in the Institutional Investor Services division. Darren Appannah Darren Appannah is a Managing Principal in Capco’s Capital Markets practice. Darren is responsible for the delivery of strategy and business transformation focused projects for clients including global banks, broker dealers, wealth and investment managers, clearing firms and stock exchanges. Darren has led the research and development of a number of thought pieces and contributed to Capco’s leading-edge thinking on a number of industry topics. Prior to joining Capco, Darren worked for Ernst Young Management Consulting in their Financial Services practice, focusing on managing large-scale business transformation projects.
- 42. 30123 GB-PAS-GLB-5-10 About Us Pershing AdvisorSolutions LLC (member FINRA/SIPC) is an affiliate of Pershing LLC and a leading custodian to independent registered investment advisors and dually registered advisors working in conjunction with many of Pershing LLC’s introducing broker-dealer customers. Pershing LLC (member FINRA/NYSE/SIPC), a BNY Mellon company, is committed to delivering dependable operational support, robust trading services, flexible technology, an expansive array of investment solutions, practice management support and service excellence. Through an innovative custody platform, Pershing Advisor Solutions delivers superior expertise and scalable and customizable solutions to help independent registered investment advisors manage and grow their businesses. Additional information is available at www.pershingadvisorsolutions.com. About Capco Capco is a leading global provider of integrated consulting, technology, and transformation services dedicated solely to the financial services industry. Our professionals combine innovative thinking with our unrivalled first-hand industry knowledge to offer our clients consulting expertise, complex technology and package integration, and managed services to move their organizations forward. Through our collaborative and efficient approach, we help our clients successfully increase revenue, manage risk and regulatory change, reduce costs and enhance control. In North America, we specialize in Banking; Capital Markets; Wealth and Investment Management; Finance, Risk Compliance and Technology with offices in Chicago, D.C., New York, San Francisco and Toronto. To learn more, contact us at + 1 212-284-8600 (+32 3 740 10 00 from outside the United States or Canada), or visit our Web site at www.capco.com.