Friday, September 18, 2009

Asset Allocation in a Flat World (think globally, not locally)

Global Diversification
One of the three big questions investors must consider today is: How and how much should one allocate to stocks in and outside of the U.S.? In his book, "When Markets Collide," author Mohamed El-Erian describes a multilateral economic future in which domestic demand in emerging markets is a counterbalance to U.S. growth. His recommendation is that U.S. investors be exposed to a globally diversified set of stocks, with only a third to one-half in the U.S.


If you agree, and we do, then what does "globally diversified" actually mean and how do you determine how much and where?


The difficult issue is determining a valid reference point. The obvious approach would be to start with an established benchmark as a frame of reference. A good neutral frame of reference would be the total world stock market value, except for the risk that constantly annoys capitalization weighted markets - you potentially overweight overvalued markets! A better alternative might be economic size as measured by GDP in that the weightings are not affected by short-term market momentum or overvaluations.



The total world stock market value and GDP for 2008 is as follows:
mkt. value GDP
U.S. 36% 23%
Europe 26% 36%
Asia Pacific 28% 26%
Mid East/Africa 3% 6%
Americas 4% 7%
Canada 3% 2%


Implementation


The most common approach is to achieve targeted international equity country weightings using a combination of developed international and global emerging markets strategies. Alignment with the MSCI EAFE (Europe, Australasia and the Far East) and the MSCI EM (Emerging Markets) Index will accomplish this.


These markets vary from relatively to significantly inefficient, therefore our suggestion would be to engage active portfolio managers who have the ability to create alpha (excess risk-adjusted return) consistently (keep the index funds for your short duration fixed income funds and large cap U.S. funds).


It is possible that the next ten years will bring lower correlations of international markets with the U.S., as regions like Asia decouple as they mature and become less dependent on the U.S. and continue to demonstrate growth in their domestic economies.



Christopher Blakely Sept. 2009

sources: International Monetary Fund, MSCI