Global Investing in the Real World (or, Maybe, Real Investing in a Global World)

Let's take a look at just a few of the more serious challenges faced by an investor who wishes to adopt a global investing approach.

Is “Global Equities” an Asset Class?

When thoughtful investors design portfolio strategies, they begin with the concept of an asset class. By mixing and matching different asset classes in a sensible way—that is, taking advantage of less-than-perfect correlations among the asset classes—they are able to build portfolios that optimize return per unit of risk. I don't wish to get bogged down in the debate over what constitutes an asset class, but for portfolio construction purposes it is generally useful to divide investment assets into smaller, rather than larger, categories. For example, using as building blocks for a portfolio such categories as U.S. large-cap stocks and U.S. small-cap stocks makes more sense than trying to design a portfolio around one huge asset class called “U.S. equities.” By using the finer definitions, families can tailor the portfolio to their needs much more carefully, and they are also likely to end up with a better-diversified portfolio.

Extending this thought to global equities, I would make the same comment: The term is too broad, too encompassing, to be of much use in the design of investment portfolios. It incorporates all the domestic asset classes mentioned above, as well as non-U.S. large-cap equities, non-U.S. small-cap equities, emerging markets equities, and even frontier markets. If an investor simply turns all the securities over to one global equities manager, what chance is there that that manager will create an efficient portfolio? The answer, of course, is “little to none.”

Of course, one argument for investing globally is that correlations among world markets have become so high that the former usefulness of asset class distinctions like U. S. and EAFE (Europe, Australia, and the Far East) no longer matter. Certainly it is true that correlations between the S&P and EAFE have risen from roughly 0.40 in the early 1980s to roughly 0.80 in the first decade of the twenty-first century, driven by the collapse of the sponsor of socialism in 1989. But U.S./non-U.S. correlations have always followed long, cyclical patterns, and it is not yet clear that today's high correlations represent a whole new paradigm. For example, the correlation today between the S&P 500 and the MSCI Emerging Markets Free Index is also very high—roughly 0.75. Does anyone expect that high correlation to persist long term?

Is It Possible to Succeed as a Global Equity Manager?

Theoretically, if a manager is talented, the larger the opportunity set the better his returns should be. But the opportunity set for global equities is so vast that very, very few investment organizations can possibly amass the resources required to succeed with the strategy. Moreover, the firms that do possess those resources tend to be the kind of organizations (i.e., very large ones) in which stock-picking talent has not traditionally blossomed. As a result, many firms that offer global equity products stick to index or enhanced index products, rather than attempt active management in so vast a sector. Thus prospective global investors must ask themselves these questions:

• Do I only want an indexed approach, and if so, why not get it by, say, mixing the Russell 1000, Russell 3000, MSCI EAFE, and MSCI Emerging Markets indexes, which allows me to specify my asset allocation strategy?
• Do I really want to be a captive client of a very small handful of megafirms that have the resources (at least theoretically) to invest on a global basis?
• Because global equity portfolios (other than enhanced index portfolios) tend to hold only a tiny subset of the entire MSCI World index, am I willing to live with the very large tracking error these portfolios are likely to generate?

We might also keep in mind that for decades, the name of the game in beating the MSCI EAFE was getting the Japan bet right—Japan represented so much of the EAFE that overweighting Japan when it underperformed, or underweighting Japan when it outperformed, was death to a manager's performance. Consider how much more true this is of the decision to over- or underweight the United States.

Can a Global Manager Outperform in the U.S. Portion of its Portfolio?

Research has overwhelmingly suggested that even highly diligent managers in the U.S. large-cap sector will have difficulty outperforming the index net of their fees and other costs. If this is the case, then what possible reason is there to believe that a global manager—distracted by the need to evaluate thousands of securities across dozens of countries—can outperform in the U.S. large-cap sector? Isn't it more likely, in fact, that a manager preoccupied with picking stocks all over the world will be even less likely to outperform in the highly efficient U.S. market? And won't this undercut the rationale for going global?

Do the BRICs Really Matter as Much as We Think?

The growth and influence of the Chinese and Indian societies—along with Brazil—has certainly been spectacular, and we can all be forgiven for being rather transfixed by it all. But we shouldn't make the mistake of projecting straight-line growth in these economies.

On the subject of straight-line projections, I frequently read things like this: “Growth in the Chinese economy has averaged 14 percent per year and therefore China will control 50 percent of the global economy in 30 years.” Possibly, of course, but highly unlikely. In the first place, the annual growth rates that are so casually bandied about really represent the growth rate of the large Chinese cities, not of the country as a whole. When you add in the (dismal) growth rate of the Chinese countryside you come up with a much lower number.

I discuss China in Chapter 1, but don't forget that it's a totalitarian country, and no command economy has ever made the transition from agrarian to industrial to modern postindustrial economy. The Chinese Communist Party has to give up power and democratize if it wants to keep growing the economy, but if the CCP gives up power, what will hold China together?

India, of course, has the opposite problem. It's “the world's largest democracy,” and a fractious one at that, deeply divided along ethnic, religious, and caste lines and with a massive and growing population of desperately poor citizens who are barely being touched by the rapid progress of the educated elite. The only way we know of to move a society from undeveloped to developed is to install the necessary infrastructure—roads, power, basic manufacturing, and so on—exactly what the Soviet Union and China produced and exactly what India lacks. And without a command-and-control government like China's, India is unlikely to have the necessary infrastructure any time soon.

China, like the USSR, kept its people impoverished for decades while it built the infrastructure it needed through brute force. But as a democracy, India can't follow suit. The global economy isn't interested in what India can produce in two decades; it's interested in what India can produce today—which, given its educated elite, means services. But as far as I know, a service economy won't carry India as far as it needs to go without vast improvements in its basic infrastructure.

Brazil utterly dominates South America, being the largest country in both land mass and population—indeed, Brazil's population is larger than that of all the other countries of South America combined. Nonetheless, it's only about two-thirds the size of the United States and vastly smaller than China and India. And like most of South America, Brazil has suffered for centuries without a large middle class—in Brazil, you were either phenomenally rich or dirt poor.

More recently, Brazil's middle class has begun to grow, an enormously positive development. But the country is still very much a work in progress. Brazil's economy is mainly dependent on natural resource production and agriculture, it lacks control of its waterways (and in any event they run in the wrong direction), and the natural geography of the country impedes development.

In my view, Russia doesn't even belong in the same category as the other three countries. Although it is the largest country in the world by far in terms of land mass, its population is less than half that of the United States and is 50 million people smaller than Brazil. In addition, Russia's population is rapidly aging, its economy is more a kleptocracy than a free market, and democracy in any real sense has yet to take hold.

Don't get me wrong—the growth in the BRICs is real, and rapid improvement in living standards in the world's most populous countries is the most important story of the past half century. The question is whether that growth, and the investment opportunities it makes possible, can possibly keep up with the current optimistic expectations.

What about Investing in Multinationals?

Many investors argue that the main benefits of global investing, without many of the downsides, can be obtained by investing in global, multinational companies, regardless of where they are domesticated. That would be nice if it were true, but at the end of the day a portfolio of multinationals turns out to be mainly a U.S. domestic portfolio. Of the 50 stocks in the Dow Jones Global Titans 50 index, for example, fully 28, representing 62 percent of the market capitalization, are U.S. companies.³ Moreover, the multinationals portfolio tracks the Dow or S&P 500 very closely, meaning that it offers little diversification.

The Challenge of Stock-Picking in “Non-Nonsynchronous” Markets

In the most developed stock markets, stock behavior tends to be nonsynchronous; that is, the complement of stocks traded on those markets don't tend all to move in the same direction. In the United States, for example, in most weeks roughly 58 percent of the stocks move in the same direction. By contrast, in China more than 80 percent of the stocks move in the same direction.⁴ In non-nonsynchronous markets, why pay an active management fee to a global manager when an ETF would be a lot less expensive?

Thinking Nonmonolithically

Although I have tended to talk in this book—for simplification purposes—as though global equities consisted of only two subcategories, U.S. and non-U.S., in fact the world is vastly more complex than this. U.S. equities includes large-cap, mid-cap, small-cap, microcap, hedge, venture capital, buyouts, and the large group of quasi-equity investments that includes mezzanine, distressed, turnarounds, and so forth. Non-U.S. equities includes EAFE, emerging markets, global small-cap, hedge, venture capital (in the UK and Israel), buyouts (in Europe), and so on. Accessing this vast and diverse opportunity set through a global equity manager, even among long-only asset classes, would be, to say the least, challenging.