Is it too late to invest offshore?

Co-founder of the Switzer Report
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The latest data from the ATO shows that SMSFs are massively underweight offshore investments, compared to their institutional counterparts and the exposures recommended by the traditional asset allocation models. The ATO reports that offshore investments by SMSFs stand at $11 billion out of a total investment pool of $746.6 billion, a weighting of just 1.5%. A typical  weighting under the traditional models for a “growth” portfolio should be in the order of 25% to 30%, for a “balanced” portfolio 15% to 20% and even for a “defensive” portfolio”, 5% to 10%.

Due to classification issues with how trustees report holdings of ASX-listed international products, the ATO’s figures are on the low side. And with the tax benefits from franking credits, there’s a good reason for trustees to have a bias for local shares. But even so,  the hometown bias is extraordinary. Is this because some trustees don’t know how to invest offshore, or following a decade long bull market, feel that it is too late to invest offshore?

My answer to the second question depends on the level of exposure and investment objectives, and is based on the premise that “time in the market” rather than “timing” will work better for most investors. Hence, if you are a long term investor with limited offshore exposure, then “no”, it is not too late. If you’re worried about the market, an alternative to broad market exposure might be to invest with a conviction style manager who might be less impacted by a market down-turn.

If you are positioned close to your recommended weight or want to play it more from a trading perspective, I think you can afford to be patient and wait for better opportunities.

More on this later. First, let’s do a quick re-cap on the “why”, “where” and “how” of investing offshore.

Why invest offshore?

There are 3 main reasons to invest offshore.

Firstly, the Australian market is small – less than 2% of global stock markets by capitalisation. This means that 98% of opportunities are outside Australia.

Secondly, our market is dominated by financial and resources stocks. The financials sector makes up 32% of the Australian market, compared to 13.2% in the USA. For materials, it is 18.5% compared to 2.6%. Conversely, information technology stocks make up 21.1% of the US market compared to a trifling 2.3% in Australia. Our market simply doesn’t have the Apples, Alphabets, Amazons, Microsofts or Facebooks, or in the healthcare sector, pharmaceutical giants like Pfizer, or consumer giants Johnson & Johnson.

Thirdly, international share markets will often outperform the Australian market. While this can be true over any short-term period, it is also true over a longer period. The following graph from the RBA shows the performance of Australian (black), US (red) and World (developed markets, blue) over a 25 year period, using a common base and logarithmic scale.  Over this longer period, the US market has outperformed the Australian market.

Where to invest?

The MSCI ACWI Index, which is a leading global share index, captures almost 2,852 large and mid-cap stocks from 23 developed markets and 26 emerging markets. In this index, stocks from the USA account for 55.0% by market weight, with Japan coming in second at 7.3% and the UK third at 5.1%.

In a relative sense, emerging markets such as China (excluding Hong Kong, which is classified as a developed market), South Korea, Taiwan, India or Brazil are very small. In aggregate, less than 12%.

Further, the US market is the lead market for most others. If the US market catches a cold, it is very hard for other markets to sustainably move in the other direction.

So, investing offshore for many investors is firstly about whether to invest in the USA or not. While you can just invest in emerging markets or Europe, it is higher risk not to have some exposure to the USA. Over the last 25 years, the US market has outperformed the other major markets, as the following graph from the RBA shows (US in red, Euro area light blue, UK dark blue and Japan brown).

Since the GFC, the USA and most developed markets have outperformed emerging markets. The following graph shows the Developed World (in black), Emerging Europe (green), Latin America (purple), China (pink) and Emerging Asia (brown).

In 2019, Australia has outperformed most of the major markets, largely due to a post-election some catch up and the spike in the iron ore price. Most markets are in the green, with Asia lagging the USA and Europe.

Source: Bloomberg, to COB 14 June 2019

While the US dollar is easing (which in theory should be a positive for emerging markets), the uncertain trade picture that is impacting Asian markets and the weak outlook in Europe suggests that investor flows will still be focused on the USA.

How to invest offshore

Many of the major brokers (CommSec, nabtrade etc.) provide facilities to invest directly in individual shares or other securities that trade on the major exchanges. You might, for example, be interested in the FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet (Google’s parent) or their Asian equivalents, stocks like Baidu, Alibaba or Tencent.

For the occasional offshore investor, nabtrade offers an excellent service. $19.95 brokerage on a trade between $5,000 and $20,000, with no custody fee provided you do at least 1 trade annually. There is however a spread on the currency conversion which applies to both buys and sells.

Many investors will probably prefer exposure through a broader based, managed investment. The question then becomes whether to have that managed passively or actively, or a combination of both.

Exchange traded funds are passively managed investments that are designed to track a major index such as the S&P 500. Traded on the ASX, ETFs generally have very low management fees because they are effectively on “auto-pilot”. Your return will be the same as how the index performs less the management fee – nothing more, nothing less.

These are the ETFs to use:

For an active manager, you may wish to consider some of the listed investment companies and ASX quoted managed funds. Investment styles and areas of focus vary. These are some of the major funds to consider.

Magellan and WCM (the manager of WQG and quoted fund WCMQ) boast remarkable performance records and have demonstrated that their investments tend to be less impacted in poor markets. But as “bottom up, conviction style” managers, “manager risk” is a consideration for investors, who may care to diversify by spreading their investment across different managers.

It is important to disclose that I am a Non- Executive Director of WQG and could be considered to have a conflict of interest when it comes to discussing WCM and WQG.

Hedged or unhedged?

One of the considerations about investing offshore is the direction of the Australian dollar. Active managers will often prefer to manage the currency risk dynamically, hedging when they believe it is appropriate. Some active managers will hedge all exposures, while others will run an unhedged exposure.

Many exchange traded funds now give investors the option of taking a hedged or unhedged currency exposure. For example, iShares IVV tracks the US S&P500 index and exposures are unhedged, while IHVV tracks the same index but exposures are hedged back into Australian dollars. The hedged version is typically a little more expensive.

Where is the Aussie dollar  heading? Many commentators expect the Aussie to weaken in the medium term, feeling that a subdued economy, lower interest rates and a weaker outlook for global growth (which should mean lower commodity prices) will exert downward pressure. But the  recent spike in iron ore prices (following the disaster in Brazil) has supported our dollar.

On a longer term basis, the Aussie looks to be close to what many consider to be fair value (around US 70 to 75 cents). The following chart from the RBA provides a 34-year perspective (US dollar red, YEN brown, EURO blue).

I am not a huge fan of hedging because in the main, currency movements tend to wash out over the longer term. But if the Aussie goes lower and gets even cheaper, this is where a hedging strategy could make sense. If it was to go the other way back over 80c, I would look to lift any hedges and invest on an unhedged basis.

Is it too late?

And offshore markets? As Peter has discussed, we don’t see any immediate threat to the continuation of the bull market in 2019. It is certainly maturing and 2020 might be a different proposition. Lower interest rates are a hugely powerful force, but they are also a function of a slowing economy. President Trump remains a wildcard. In theory, he should want the trade dispute settled, a strong US economy and a buoyant US stock market as he heads into the  election season, but he has surprised the market before and could arguably be the “black swan event” we can’t foresee . And of course, after such a strong start to the year, that doesn’t mean that there won’t be a pullback, however there is no reason to suggest that the trend has changed yet.

Bottom line – for a long term investor with limited or zero exposure to offshore markets, I don’t think it is too late. If you are already invested, perhaps wait for a bit of a pullback. Alternatively, look at managers who offer a high conviction style approach to stock selection and potentially might be better placed to ride out any general market downturn.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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