Working in the investment management industry over the years teaches you several things which are not necessarily found in your typical text book, including the preference for investors to invest in their local stock exchange. This characteristic is present in all investors, not only Maltese. The primary reason behind this is the belief (among investors) that their knowledge and understanding with respect to the operations of local companies is greater when compared to foreign entities.
If this greater knowledge is based on the fact that a local investor can see or touch the local company, then they are right. But dealings with a company, or being able to see or touch a business should not be the sole reason for making an investment decision.
When structuring an investment portfolio, it is important to bring together a number of different factors to achieve a well diversified position. These provide the potential for achieving an attractive risk adjusted rate of return. Knowing your underlying investments thoroughly is a very important starting point – being in a position to analyse the operational progress of the company, not only through the analysis of the company’s financial reporting and periodic trading statements, but also through regular meetings with the firm’s management.
Through a combination of skill, analytical expertise and a strong rapport with the firm in question, one could also begin to forecast the financial results of that firm. This will allow the investment advisor to make recommendations based on both the past as well as the predicted financial performance of the firm in question. Such work and analysis is imperative to achieve a consistent track record of attractive risk adjusted returns.
This work is important but far from enough. Knowing your investments to this degree does not entirely de-risk your investment portfolio – there remains macro-economic risk which still needs managing. For example, it is all well and good to know your investment thoroughly as explained above, however, if all your investments were local companies situated in North Africa then your entire investment portfolio will be affected in the same way irrespective of the industry each company operates in. An investor should want to invest globally for two primary reasons; risk reduction and return enhancement. An investor can reduce risk by investing in foreign assets with relatively lower correlations. Correlation is the relationship between two variables.
Going back to North Africa, one can see a very strong correlation between the political and civil state of the nation and the increase in investment risk across all sectors and industries within that nation. Hence, when we speak about diversification we must also speak about correlations. Investing globally should expose the investor to an increased number of investment opportunities with low or even negative correlations.
Such correlations from foreign assets also indicate that higher risk-adjusted returns may be achieved since asset markets may move independently of one another (zero correlation). Even though the total risk of foreign assets is often higher (mainly due to currency risk), adding a foreign asset to a portfolio will reduce portfolio risk if correlations are sufficiently low. The primary factors that cause economies to behave independently and their resulting correlations to be low are: government regulations, technological specialisations, fiscal policy, monetary policy, cultural and sociological differences.
Therefore, investing globally provides the potential of achieving more effective diversification but also adds risk. There are two main risks to be considered at this point: foreign currency risk and company specific knowledge and understanding.
Currency risk can be very easily hedged away either via specific instruments such as currency derivatives or via a diversified portfolio of many foreign currencies which have low or negative correlations with one another. Chances are that currency risk will be diversified away in a portfolio of many foreign assets.
Company specific understanding is always crucial, however, nowadays with the number of investment houses one finds that almost all the major global companies scattered around the globe are followed and analysed by a number of analysts thus company information and research is becoming less of an issue.
Finally, it is important to note that stock returns are less dependent on the country where the firm is based and more dependent on the industries in which the firm operates. Industry factors become more important as corporations become more global and more narrowly focused in a singly industry. Investing globally diversifies across industries as well as countries, in contrast to traditional international diversification which only considers country diversification.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business. Should one wish to discuss this article in further detail, he or she may contact the author on 2342 6127.
www.curmiandpartners.com
Mr Micallef is an investment executive at Curmi and Partners Ltd.