(p.291) Appendix B Global Investing for Pension Funds
(p.291) Appendix B Global Investing for Pension Funds
By the end of 2000, U.S. pension funds were allocating 10% of their portfolios to international securities.1 One reason for this exposure to international investment is quite simple: international securities represent a significant fraction of all investable capital worldwide. As of the end of 2001, foreign equities accounted for about 19% and foreign bonds accounted for about 24% of total investable capital.2 Thus, pension funds needing a place to invest are virtually forced to look overseas for additional investment opportunities. Another reason for international investment is the potential benefits of international diversification. In addition, some analysts also argue that some overseas markets may not be as efficient as the U.S. marketplace. Thus, there may be occasions for earning positive risk-adjusted excess returns from active global management.
Investing in foreign securities is not the same as investing in U.S. securities. There are at least two questions pension funds should ask when investing outside the United States: does the country of interest have a mature economy that should grow at a modest but relatively stable rate, or is it an emerging economy that could grow explosively but erratically? Are the local markets governed by competitive forces, or are they subject to government regulation and intervention? The answers to these questions are important in selecting exposures and investment strategies.
International investing also has a risk/return profile that is different from investing solely in domestic markets. For example, currency exposure can be an important determinant of realized total return. The risks and returns of foreign equities and bonds are also different from those of their U.S. counterparts—or at least they have been. Significant differences also may exist in the market structure of foreign markets as well as in information availability and regulation. Of course, the fundamentals of the economy of a specific country or region may vary widely.
(p.292) CURRENCY, RISK, RETURN, AND DIVERSIFICATION
Changes in currency exchange rates can affect the short-run returns from investing in international securities. To some, this foreign-exchange risk offers opportunities: they attempt to forecast currency valuations and thus pursue active (and, it is hoped, profitable) currency management. According to others, currency risk is simply an unsystematic risk to be avoided and thus hedged or eliminated by diversifying. Currency risk may be partially diversified away by holding investments denominated in numerous currencies simultaneously as long as these currencies are not strongly correlated. Derivatives offer the opportunity to hedge currency risk fully at low cost, if such a hedge is desired. Whether to hedge at all is an issue, however, that becomes more and more important as more pension assets are invested overseas. We discuss this in some detail in Chapter 20.
Non-U.S. equities may be divided into the same categories used for U.S. equities: large and small company equities, value and growth equities, and so forth. There is much more to the story, however.
The conventional wisdom is that diversification into foreign equities makes sense because foreign equities have a positive but far from perfect correlation with domestic securities. There is evidence, however, that with globalization, the correlations are increasing and, hence, the advantages of diversification are diminishing.3 There is also some evidence that the correlations increase in bear markets, meaning that just when low correlations are needed, they may disappear.4 That said, even though correlations between country markets may have increased, a global perspective is essential in constructing portfolios. For example, suppose a pension fund decides to increase its exposure to a particular industry. Because of increasing globalization, the fund should consider all the competitors in that industry—not just those that are headquartered in the United States.5
In addition, managers should consider international investments in emerging markets as well as in developed markets. One recent study found that emerging-market investors should keep an eye on domestic economic policy. In particular, the study found that the benefits of investment in emerging markets were highest in periods of restrictive U.S. monetary policy.6
Currency risk is a central issue when investing in foreign bonds. It accounts for as much as half of total bond market risk. The historical record for unhedged foreign bonds in U.S. dollar terms indicates that the returns are (or have been) more volatile than U.S. returns are. Although there seems to be a modest diversification benefit to be gained by adding unhedged foreign bonds to portfolios of U.S. bonds, authorities disagree on the desirability of doing so.
(p.293) Hedged foreign bonds have performed very well when compared with unhedged foreign bonds and with U.S. bonds. However, the periods studied are characterized by financial markets that are now less regulated and more integrated than they were in the past.7 In addition, U.S. monetary policy could have affected the historical results. In other words, the seemingly superior historical performance of hedged foreign bond portfolios should be viewed with caution: the environment can change, and as more investors globalize their portfolios, free lunches are not likely to persist. (Indeed, they may not have been really free in the first place.)
Overall, the evidence on the performance of foreign bonds shows neither overwhelmingly good nor overwhelmingly bad results. For pension funds that have currency exposures resulting from benefits payable in non-U.S. currencies, foreign bonds offer a natural hedge. Foreign bonds may also offer the potential to exploit interest rate or currency views and security selection opportunities for those pension funds that believe in active management.
A currency overlay is a portfolio management activity that assigns the authority to manage currency risks and returns to an overlay manager. The overlay manager may attempt to enhance portfolio returns by taking positions in currencies on the basis of a particular view of how a given currency will do relative to other currencies. However, the overlay manager may attempt to reduce the portfolio's exposure to currency risk by hedging all or a portion of the portfolio's net currency exposure.
The appeal of a currency overlay is twofold. First, there is a specialist, who presumably understands currencies and currency management. Second, there is someone who “sees the big picture” and has the authority to make decisions according to the net exposure a pension fund may face or want.
In one study, currency overlays were compared with portfolios that were formed by jointly selecting currency and asset class weights.8 The conclusion was that currency overlays are inefficient relative to portfolios that integrate the asset class/currency decisions, indicating that the interaction between assets and currencies is not fully considered in the overlay approach. Overlay managers may be able to add value through active management, but this may be suboptimal compared to a fully integrated approach.
THE REGULATORY AND INFORMATION ENVIRONMENT
Structural issues should be of special interest to pension funds as they globalize their investment portfolios. Deregulation and integration of markets throughout the world have led to generally lower costs of international investing, better information, and more efficient trading mechanisms through computers and electronic communications. However, it is still more costly to trade in most markets outside of the United States—as much as twenty-five to seventy-five basis points more costly.
(p.294) Another factor that must be considered is that taxes—ordinarily not a problem for U.S. pensions—can be an issue when investing in foreign securities. Withholding taxes on dividends and interest may come into play and may or may not be fully recoverable, depending on the tax treaties in effect with the relevant countries.
Securities regulation may also differ substantially among the different countries. There is no Securities and Exchange Commission (SEC) outside of the United States, although there may be roughly analogous counterparts to the SEC. Accounting standards vary from country to country, making it difficult to interpret whatever financial statements are presented. There may also be restrictions on foreign investment that make certain investment positions unobtainable. For example, in some countries, foreign investors may be prohibited from taking positions in certain securities.
The bottom line for pension funds is that international investing poses new challenges with respect to information, regulation, and structural issues. As a consequence, pension funds and their managers must recognize that the rules for international investing are not the same as those for domestic investing. Investment strategies that rely on timely, high-quality information; speedy trade execution; or low transaction or custody costs may not work in some markets. Thus, international strategies that will achieve the goals of the pension fund are likely to differ from traditional U.S. strategies: they will have to adapt to the countries to which they are being applied.
There are also other issues for pension funds that choose to invest internationally. Not the least of these is finding experienced managers. For pensions that prefer passive investing—and there are many funds that favor passive investing abroad to keep transaction costs low—experienced management simply means being conversant with the trading mechanisms and exchange characteristic of the target countries or regions. For pensions that pursue active management strategies, managerial expertise becomes even more important, because countries differ greatly by accounting standards, quality of information provided, and so forth. Traditional security analysis is also likely to be substantially different in different countries because of the difficulty of properly analyzing the effects of demographic, social, and political factors on asset values, and also because of the difficulty of getting high-quality data for use in analysis.
Pension fund decision makers who believe in active management have, in the international market, a larger set of strategic opportunities than is available in the United States. Pensions can attempt country selection strategies (how countries are expected to perform economically relative to other countries) and currency selection strategies (which currencies are expected to do well relative to other currencies). Even proponents of efficient markets may be attracted to emerging markets on the basis of the possibility of inefficiencies resulting from information problems or trading frictions. Of course, information is costly, and inefficient trading systems may interfere with otherwise profitable trades. More (p.295) over, some emerging markets may never emerge, failing to survive long enough and to provide reasonable return for the risk taken. It is worth noting that emerging markets account for only about 3% of the total capital markets.9 Pension fund managers should think carefully about where they are focusing their time and resources. A lot of return on 3% of a portfolio's assets will not offset a poor strategic asset allocation.
Overall, it seems that large and medium-sized pension funds should be thinking along the lines of developing and implementing optimal global investment strategies as opposed to domestic-only strategies. Sponsors of employee-directed plans should include one or more non-U.S. alternatives to employees as well. However, the track record of risk/return data for non-U.S. investing is not as long as it is for U.S. securities. The world has changed rapidly, and given the probable effect of currency on the historical data, we have to be careful not to infer too much from the historical record. The U.S. companies in which pensions invest are increasingly exposed to currency and country risk through their normal operations, as well. Sponsors have more multinational workforces than ever before, and U.S. securities markets, relative to those of the rest of the world, are smaller and less capable of meeting the investment needs of pension funds than they were several years ago. Thus, foreign markets seem to offer reasonable and fertile investment alternatives for U.S. pension funds.
Pension funds should be willing to invest outside the United States. Domestic-only portfolios are likely to be inefficient, providing too little return for the risk taken. To globalize, however, the sponsor needs to take a broader perspective in terms of many of the topics considered in this book. For example, the strategic asset allocation decision now becomes one of choosing not only asset classes but exposures to regions, countries, and possibly sectors within those countries. In addition, the strategic asset allocation now must address a currency component. Performance measurement also takes on additional complexity. For example, returns will normally be stated in terms of the investor's base currency and will be a function both of local investment returns as well as of relative currency movements. Benchmarking must become more robust, as the scope of the benchmark must expand to include countries as well as asset classes. These country exposures make determining the appropriate set of benchmark weights a more difficult task because appropriate weightings can be determined by amount of assets held, the total market capitalization for a given country, or the gross domestic product for a given country.
We offer the following caveats. Remember that the risk/return characteristics of non-U.S. markets are not as well documented as they are for U.S. securities. In the international marketplace, trading is more costly, and information is more uneven in quality and is still more costly. The magnitude of the benefits of diversification is open to debate, and the effect of currency risk is both real and somewhat confusing. Go cautiously, pay attention, do not forget about the bigger issues such as strategic asset allocation, and as always, do not expect a free lunch.