How well are you really doing in global shares?
While the Australian share market has stolen the headlines, global equities have also performed strongly in recent years. Most funds take an active approach to this sector, and are looking for their managers to outperform a passive benchmark. But does the index they’re using reflect the reality of how their fund invests? If not, how do they know how well they’re really doing?
Global shares are a major component of most growth-oriented super funds. Not only that, many funds also offer global shares as a stand-alone investment option. So this sector is probably second only in importance to Australian shares in terms of how satisfied members are with a fund’s performance.
But global shares – by definition – covers a vast investment space. Different markets perform in different ways at different times, and most funds structure their allocation and manager line-up to capture as much of the available return as they can, subject to their risk controls.
Where have the best returns come from in recent years? The answer is emerging markets and smaller companies. Table 1 shows that over the four years ended June 2007 the most commonly-used benchmark, the MSCI World ex Australia (Unhedged) Index, returned 11.5% pa in Australian dollar terms. Against that, the MSCI Emerging Markets Index returned a stunning 29.5% pa and the MSCI World Small Cap Index 16.1% pa.
Table 1: Performance of Global Shares Indices – to 30 June (% PA)
| | 2004 | 2005 | 2006 | 2007 | 4 YRS TO JUNE 2007 | | MSCI World ex Aust A$ | 19.4 | 0.1 | 19.9 | 7.8 | 11.5 | | MSCI Emerging Markets A$ | 28.5 | 23.3 | 39.4 | 27.4 | 29.5 | | MSCI World Small Cap A$ | 35.2 | 3.8 | 23.1 | 5.2 | 16.1 |
Most multi-manager funds now include some exposure to emerging markets and small caps, usually by giving specific mandates to managers who specialise in those areas or by giving global managers very broad mandates. So, given what we know about the performance of the different indices, the returns of those funds should be looking very healthy in recent years. And indeed they are, when they are set against the conventional benchmark.
That point is clearly illustrated in the following graph. It shows the excess returns of our international share fund universe against two different indices – the conventional MSCI World ex Aust Index and the MSCI All Country World Index, which is not limited to developed markets or large cap stocks (although it doesn’t include small cap stocks).
It is evident that an unconstrained, fully diversified fund that includes emerging markets exposure has effectively been getting a ‘free kick’ in the order of 1% to 1½% excess return if it has only been measured against the conventional index.
That may make the fund look good in the eyes of members, but trustees need to be aware of any mismatch between the composition of their fund and the benchmark they are using and bear that in mind when assessing performance.
The Currency Effect Another possible mismatch arises from the fact that the conventional benchmark is typically the unhedged version of the index. That can have a significant effect on relative performance over periods when there has been a major realignment of currencies, as we have seen recently.
The recent decline in value of the US$, and the fact that 47% of the MSCI World ex Aust index is denominated in US$, means that the performance of the index has been much stronger on a fully-hedged basis. Looking again at the 4 years to June 2007, the fully-hedged index has outperformed the unhedged index by a full 5% pa (16.5% pa against 11.5% pa).
Table 2: Performance of Hedged V. Unhedged Indices – to 30 June (% PA)
| | 2004 | 2005 | 2006 | 2007 | 4 YRS TO JUNE 2007 | | MSCI World ex Aust A$ (unhedged) | 19.4 | 0.1 | 19.9 | 7.8 | 11.5 | | MSCI ex Aust Local * | 20.2 | 9.8 | 15.0 | 21.4 | 16.5 |
* This index has been used as a proxy for the MSCI World Ex Australia A$ (Hedged) Index
That is important because the reality is that most funds do include a degree of hedging in their strategy. Sometimes that is at the sector level (eg in a stand-alone global shares option) but more commonly at the diversified option level. They achieve that either through their mandates, by allowing underlying managers to manage currency at their discretion, or by way of a separate currency overlay.
The Chant West June 2007 strategic asset allocation survey shows that for Growth funds (defined as having between 61% and 80% in growth assets), the average allocation to international shares was 27%. Of that, 10% was hedged back to A$ (17% was unhedged), representing an average hedge ratio of 37%. Interestingly, the range of strategic hedge ratios covered the full spectrum from 0% (fully unhedged) to 100% (fully hedged). Over 75% of the funds have a hedge ratio between 30% and 50%.
Again, given what we know about recent currency movements, any fund that benchmarks itself against the unhedged index would have received another ‘kicker’ to its excess return, with the magnitude depending on the degree to which it was hedged.
Even a small difference in hedge ratios would have had a significant effect. For example, over the year to June 2007, maintaining a hedge ratio that was 10% away from the industry average (27% / 47%) would have had a gross performance impact of about 0.3% for the typical Growth fund.
Beware of Looking Through Rose-Tinted Glasses We have shown how, in recent years, the conventional MSCI World ex Aust (Unhedged) Index has proved to be a fairly ‘soft opponent’ in terms of a benchmark to beat. That is because it measures the performance of mid to large cap stocks in developed markets only and on an unhedged basis – not the best place to have been in recent years.
That does not necessarily make it irrelevant or inappropriate, and nor will it always prove to be an ‘easy beat’. The industry, and certainly the investing public, needs a simple, standard measure by which to set expectations and gauge performance. For most purposes the conventional index – despite its limitations – will often suffice.
As the industry becomes more sophisticated, however, some players are adopting benchmarks that are better aligned to the realities of how funds invest. In this, asset consultants are generally leading the way while others are considering the matter. Chant West, for example, is considering the implications of adopting the MSCI All Country World Index as the benchmark in our surveys
Whatever index is used, it is important to bear in mind exactly what it is measuring. Otherwise, the danger is that you may be looking at fund performance through rose-tinted glasses.
Disclaimer © Chant West Pty Limited (ABN 75 077 595 316) 1997 - 2013. You may only use this document for your own personal, non-commercial use. This document may not be copied, reproduced, scanned or embodied in any other document or distributed to another party unless you have obtained the prior written consent of Chant West to do so. The information above is based on data supplied by third parties. While such data is believed to be accurate, Chant West does not accept responsibility for any inaccuracy in such data. Past performance is not a reliable indicator of future performance. The products, reports and ratings do not contain all of the information that is required in order to evaluate the nominated service providers, and you are responsible for obtaining such further information. This information does not constitute financial product advice. However, to the extent that this document may be considered to be general financial product advice then you acknowledge that you have been provided with a Financial Services Guide and Chant West warns that: (a) Chant West has not considered any individual person’s objectives, financial situation or particular needs; (b) individuals need to consider whether the advice is appropriate in light of their goals, objectives and current situation; and (c) individuals should obtain a Product Disclosure Statement from the relevant fund provider before making any decision about whether to acquire a financial product from that fund provider.
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