Country and Regional Funds: Large Potential Profits, Real Diversification, Real but Manageable Risk

COUNTRY AND REGIONAL FUNDS:
Large Potential Profits, Real Diversification, Real but Manageable Risk

by Brian Bloch

Published as “More Eggs in One Basket”, Bloomberg Money ISAS Guide
(ISAS – Essential Investor Guide and Information, February 2003, pp.40-42.)

Particularly since 2001, a proportion of astute equity investors have shifted their perspective out of the UK and America and into other regions which continue to boom. While shares languish back home and bonds offer security but little return, parts of Asia, Eastern Europe and elsewhere have been doing even better than the UK and USA markets at the height of the boom.

If one goes back to the fundamentals of asset allocation, it is clear that many investors favour their home countries excessively. This reduces diversification and increases risk, as so many British investors have discovered – and too late to avoid substantial losses.

There are lessons to be learned and money to be earned for those who have sufficient tolerance for risk or at least the ability to control it. With a greater than 50% rise in Indonesia over the past few months, Thailand at over 25% and South Korea yielding more than 20% last year, it is obvious that investors in the right place at the right time, are making big money, while elsewhere, people are licking their wounds.

Russia is currently being celebrated as the “bull amongst the bears”. Over the last four years, Russian equities have risen by an average of over 300%, and the broker house Troika Dialog still regards oil stocks as undervalued. Some African funds too, have done remarkably well.

In 2001, some analysts were predicting just such trends, and these analysts were right. The fact is, there is always a boom somewhere. It is not always difficult to find such regions, and before investors are at the point of “chasing trends”. Consequently, it can be argued that country funds represent a risk worth taking.

We are so used to the FTSE and Dow-Jones, that we tend to overlook how easy it is in this high-tech age, to follow indices and developments anywhere in the world. And given the misinformation and accounting scandals that are constantly breaking in the UK and USA, there is no reason to believe things are necessarily worse elsewhere. They may even be better.

The essential benefit of country funds follows from a basic principle of investment – success comes from seeking out the best opportunities, wherever they may be. Of course, moving out of familiar territory has its own risks, but then, so too did the high tech shares so close to home. and they dragged just about everything else down with them. But only everything close to home.

Nonetheless, there are real dangers, such that country funds should be handled in a very specific way. To achieve the objective of avoiding too many British shares, it is generally necessary to invest in markets that have a low correlation with the UK. Thus, a USA or broad European fund will not do the job.

Funds are the usual way of investing. Individual shares in Asia, Eastern Europe or South America would be pushing the luck of most investors too far. Here, distance and a lack of familiarity create substantial informational and monitoring problems for investors. Is generally easier to know if an entire country is doing well and likely to continue doing so, than to judge individual firms or possibly industry sectors.

Exchange rate risks put off many investors. Yet, if non-equity assets such are bonds are kept strictly within the Sterling zone, currency risks can be kept within reasonable limits. Likewise, by spreading the non-UK investments over several (but not too many!) currencies, diversification in this context also reduces risk.

And, if, for example, three funds are held, it is possible to have one aggressive holding (a Chinese fund conforms to this criterion), one that performs relatively well when things are bad in Western Europe (e.g. Eastern Europe), and one that is well balanced, such as a truly global fund. For all but the most aggressive investors, it is important to avoid the really risky ones such as those combining hi-tech with country risk. The fund Nordasia.com is a good case in point, and which has lost 80% of its value since 2000.

Risk can be controlled ever further by putting some money into country funds in developed markets. Those who went into Austria last year, fared better than in the UK. Likewise, the markets in France, Holland and Scandinavia have done better than the global or European indices. However, as always, yesterdays winners (or lesser losers!) need to be handled with care.

How much of a portfolio should be invested in country funds? Asset allocation principles and portfolio theory tell us that with the right mix, one can increase potential returns without a significant rise in risk. It certainly makes sense to have between a third and one half of one’s EQUITY investment in non-UK shares. Of that proportion, up to one half could be invested in emerging markets. American expert Frank Armstrong, argues that that an optimum in terms of portfolio theory, is “about 60/40 domestic to foreign”. Of this 40%, a prudent proportion can be gainfully invested in higher-risk country funds. In other words, country funds can be used to “spice up” about 5-10% of a portfolio.

It is advisable to limit the investment to a maximum of three or four fund groups. Too many “bits and pieces” do not reduce risk further and merely makes monitoring and corrective action difficult. Exactly what countries or regions are selected, depends on how the various regions are doing at the time, how much money is to be invested, the time span, personal preferences and so on.

Potential gains rise as the country risk and volatility of a fund rises. However, for growth-oriented investors, this does not mean that massive losses in some funds are inevitable. But what applies to any equity investment applies even more here. Economic and stock market developments in an entire country must be monitored constantly. This must be linked to formal or informal stop-loss procedures that are implemented ruthlessly, irrespective of the temptation to “hang in there” till things improve. Investors must decide in advance, when to bail out if things go wrong, at say -20% or less. However, bearing in the mind the upside potential of markets like Russia or China, such losses may be worth risking. Likewise, even though some of these funds have up-front fees as high as 5%, they can be highly profitable.

Profit-taking at prudent levels is the other side of the coin. Getting out when one is ahead is just as important as the converse. Especially in these relatively volatile markets, one needs to “cut” one’s gains sensibly and accept that timing the peak is unlikely and risky. However, with careful monitoring, it should be possible to ride the market to very respectable rates of return.

To conclude, the strategy outlined above is not for the very fainthearted. If you want low-stress investments that are low maintenance, mixed funds, bond funds and the like are what you need. However, even a moderate degree of risk-friendliness and a prudent amount of moving in and out of country or regional funds, enhances the potential performance of most portfolios.