Despite Ongoing Concerns, Fund Investors Continue to Look Overseas for Added Equity Exposure

August 31st, 2013 by Matthew Lemieux

As 2012 came to an end many investors were in panic mode, anticipating another U.S. policy-induced selloff in the equity markets. The threat that the U.S. government would fail to come to a compromise and push the country over the “fiscal cliff” brought back memories of the previous debt-ceiling debacle, which sent markets down and eventually led to an S&P downgrade of U.S. long-term credit. But, when the sun rose on New Year’s Day, a sigh of relief seemed to wash over the markets when Congress came to a last-minute agreement. Although the deal did not address all of the outstanding issues facing the U.S. economy, it did allow investors to focus on a more logical force in the markets—the global economy.

REUTERS/Aly Song

REUTERS/Aly Song

It was this refocus that seemed to put U.S. stock markets back on an upward trajectory that resulted in new all-time highs this year for the S&P 500 and the Dow Jones Industrial Average. The initial charge was set in motion as investors showed improved appetite for risk, manifested in the strongest inflows for equity stocks and funds since the financial crisis of 2008. The term “Great Rotation” began to circulate as many believed this could be the inflection point where investors, who had injected over $1 trillion into bond funds since the end of 2008, would begin to come back to equity products in droves. But the reality was that this trend did not change much over most of the first half of 2013. The push back into equity funds seemed to come from pent-up demand, fueled by cash coming off the sidelines, not from a mass selloff of fixed income products. In fact, the aggregate inflows into bond funds over the first five months of this year were on pace or outpacing the net inflows of the past four years.

It’s true that, overall, equity funds have struggled to maintain assets since investors suffered a 56% drop in the S&P 500 from October 2007 to March 2009. Many market participants felt they could protect themselves from future tail events much easier if they were overweighted in bonds—a move supported by ever-declining yields and periodic outperformance of bonds over stocks. Safety and superior total returns—who wouldn’t buy in? But this shift into fixed income did not come at the expense of all equity fund types. The real loser was U.S. diversified equity funds—the staple of most investors’ core equity allocations. U.S. stock funds had net outflows of roughly $155 billion since the beginning of 2009. But, as investors sought to shed risk this reduction in flows to equity products was very selective. As investors pared their exposure to the world’s largest economy, they continued to purchase and often accelerated their purchases of overseas equity.

Figure 1 shows the monthly and cumulative flows for U.S. mutual funds and exchange-traded funds (ETFs) since the beginning of 2009. While investors were consistently selling out of U.S. and global products, they continued to buy international-focused offerings. [Global equity funds invest in both U.S. and non-U.S. stocks while international equity funds focus primarily overseas.] Until the end of 2012 non-U.S. funds attracted approximately $216 billion in net new cash. Even with the renewed interest in domestic stocks thus far this year (with approximately $84.2 billion of net inflows through June), international equity funds continued to keep pace through May. So, where did the majority of this new cash go, and why—in a time of heightened risk awareness—have fund investors continued to build their non-U.S. exposure?

(Figure 1) Monthly and Cumulative Net Flows of U.S.-Based Mutual Funds and ETFs

Source: Lipper, a Thomson Reuters company

Source: Lipper, a Thomson Reuters company

Let’s review the primary drivers of overseas investing. Traditionally, the purpose of diversification is to provide exposure to a series of different asset classes that do not react in the same manner to global market events. Over time this low correlation provides better diversification in terms of risk and return. The problem here is that global cross-asset correlations have consistently and significantly increased over the past decade, driven heavily by elevated macro-volatility. The integration of global economies, especially the globalization of financial markets, has created a scenario where equities—regardless of their exposure—react similarly to a common source of risk, i.e., global economic conditions. This has been especially true for equity markets across the globe as companies integrate their business models to better utilize the cross-border flows of goods and labor.

The second driver of overseas investing is the realization that different countries generate higher economic growth rates than does the U.S. In the long term stock returns are linked to economic growth, and investors can take advantage of this growth by investing in regions with higher growth prospects. But, if investors seek to receive higher returns, they must be willing to take on added risk.

What we have seen over the past several years is a combination of the two scenarios above. Of the $216 billion of net inflows into mutual funds and ETFs seen from 2009-2012 roughly $145 billion went into emerging-market equity funds. The prevailing driver of this buying has been the hope of taking advantage of the anticipated growth of the developing economies of the world. In many cases the conversation has been dominated by talk about how countries such as Brazil, Russia, India, and China (BRIC) will be the future growth engines of the global economy. As well, a majority of diversified emerging-market equity funds have over a third of their portfolio allocated to a combination of these markets.

Again, with increased diversification to international stocks, specifically emerging-market stocks, comes a higher level of risk. In the longer term most of these regions have provided positive returns, but with the recent selloff in many developing markets (the exclusion being frontier markets), most regions have ended the first half of 2013 well in the red. Figure 2 outlines the performance of a series of MSCI indices for the four-year period from 2009-2012 as well as for the first half of 2013. As you can see, all variations of equity exposure looked great during the buildup to 2013, with emerging markets leading the charge. But, all that changed in 2013. For those who have been exposed to these markets over the long term this recent weakness is probably just a blip in cumulative return, but it may be a challenge to those who jumped in more recently. As mentioned earlier, frontier markets have weathered the selloff quite well and have provided the best returns thus far this year.

(Figure 2) Performance of Select MSCI Indices, 2008-2012 & H1 2013 (Net Return/USD)

Source: Lipper, a Thomson Reuters company

Source: Lipper, a Thomson Reuters company

Outside of the emerging markets, the remaining driver of net inflows to non-U.S.-focused equity funds has been in the form of diversified international index funds (+$86.1 billion net since the beginning of 2009). This observation is in line with the first driver of international investing. These products provide easy access to a diversified portfolio of international stocks. Although not the place to find triple-digit returns over four years, you can see in the previous chart that this diversification has provided steady returns. The MSCI EAFE index was up roughly 4% in the first half of this year. (This index measures the equity market performance of developed markets, excluding the U.S. and Canada. If you are looking for added emerging-market exposure, products that benchmark to the MSCI All County World Index (ACWI) ex U.S. may be best.)

Overall, U.S. investors have been increasing their ex-U.S. equity allocation in order to both increase overall equity diversification and to take advantage of growth-driven gains. The trick is to manage this exposure in a smart way that does not increase risk-taking beyond an investor’s tolerance. As with any situation where multiple funds are held within a portfolio, it is important to understand how those products work with each other. Do the holdings in an international index product overlap with an emerging-market fund or individual stocks? Is the overall international exposure overextended, even in combination with U.S.-focused products (roughly 44% of S&P 500 revenues now come from overseas)?

The first half of 2013 has shown that investors may be more resolute in their risk aversion than previously thought. Continued concern about the Eurozone and the volatility in both the equity and bond markets has not forced investors to the door as quickly as before. But, along with the old issues come new ones. By mid-year the markets have been forced to realize that a rising-interest-rate environment and a pullback of asset purchases from the Federal Reserve may be on their doorstep. The first reactions have been large redemptions from both emerging-market and income-sensitive assets. While this may have been a short-term correction in asset prices, it could be a signal of struggles ahead. In either case investors who understand their asset exposure and risk tolerance should be better able to weather the added volatility, just as they did toward the end of 2008.

*This article originally appeared in the August 2013 issue of On Wall Street Magazine