Note: This video is part of Morningstar's December 2014 Guide to Better Investment Picking special report.
Jason Stipp: I'm Jason Stipp for Morningstar. Today, we're featuring Morningstar's Guide to Better Investment Picking, and we're talking about better overseas investment picking with senior analyst Patty Oey.
Patty, thanks for joining me.
Patricia Oey: Thanks for having me.
Stipp: When investors are looking to go overseas, I think there has been conventional wisdom that active managers have been able to beat the index for varying reasons, perhaps by avoiding Japan in years past or getting exposure to emerging markets. When you look at the evidence, though, does it seem like active managers really have been able to best the index over time?
Oey: Well, the conventional wisdom kind of implies that managers are able to consistently market-time, consistently know that, "Oh, I should be in Japan or I should be in [emerging markets] or I shouldn't be. I think we've seen that, generally speaking, no one can consistently market-time well.
But I did a very rough look at our data. If you look at U.S. equities and you look at the performance of the managers who are in the top quartile over the last 10 years, their ability to outperform the S&P 500 maybe is about 100 basis points. If you look at international large equity, the alpha is actually much higher. It's between 150 and 200. So, the data does seem to suggest that international-equity fund managers' work is able to add alpha.
Interestingly, in emerging markets, which people think is the least efficient, the alpha isn't really that high, maybe it's closer also to 100 basis points. And maybe an unscientific explanation for this is that, with emerging markets, all those individual countries are very different. The companies in them are very, very different. So, for a manager and his or her team to really know these companies really well could be quite challenging relative to international large equity.
Stipp: If I were thinking about an active manager beating an index or going with a passive product, what kinds of indexes are out there? What would the index be giving you exposure to and what should you think about if you were going to go with an index fund overseas?
Oey: When people say index funds, what they are usually talking about is a cap-weighted index. So, one thing you need to think about when you go abroad is that, with cap-weighted indexes, there are different countries. So, these country weights are weighted based on how large their capital market is.
In some ways, that could be a little bit arbitrary. So, for example, a country like Germany, historically a lot of the companies also tended to use bank debt to finance their operations. So, relative to their economy, their equity capital market is actually a little bit smaller, relative especially to the U.K. The U.K. has a very big financial market. So, it could be somewhat arbitrary.
Another thing to think about is something like the MSCI EAFE Index, which is an international-equity index minus North America. Twenty years ago, when Japan was at its peak, [the index] had a 50% weighting in Japan. So, if you were an index investor and you bought this index product 25 years ago, you would have been really heavy in Japan, and you would have ridden it all the way down. So, again, it sort of highlights how cap-weighting can be somewhat arbitrary.
Stipp: I know that you've also looked into how indexes are composed for emerging markets and some of the issues there and what you're actually getting exposure to. What should be some of the considerations that you should ask yourself or think about if you want an index in emerging markets specifically?
Oey: Again, in emerging markets even more so, the correlation between the size of the economy and the size of the equity capital market--there is more variance. Another issue that you can think about is that MSCI is considering investors who invest in China--right now, China is about 20% of the emerging-markets index--they are considering adding the onshore equities to their index. This might happen within a few years, and so China would probably go from like a 20% weighting to a 27% weighting. And in China, most of the companies are actually state-owned companies. So, if you were to invest in an index fund like the ETF [iShares MSCI Emerging Markets (EEM)], you would have a 27% weighting in China. Most of those companies are government owned. They are not necessarily well run, and you would have a very big exposure to that.
Stipp: Another thing that investors might want to look at is strategic beta, and those can give you different exposures to different parts of the world. What kinds of strategic-beta or fundamental indexes are available to you as an investor, and what kinds of questions might you ask yourself if you wanted to invest using one of those products?
Oey: I guess, personally, I'm not such a big fan of the strategic-beta indexes for international equity. Again, you have the variable of different countries and--this is my personal opinion--I think, on some level, you're seeing these strategic-beta indexes or funds being launched, and it's somewhat based on what has a good back-test or what kind of investing is trendy right now--maybe, say, something like low volatility.
But the one issue that you need to understand is that, say you have an index that's looking for dividend payers around the world, countries like Australia and Taiwan, they tend to pay out higher dividends. So, if you have an index that's looking for dividend payers, you might end up with a very large weighting in Australia and Taiwan. And generally, in the international arena, you don't want to have so much country concentration. There is a lot of idiosyncratic risk. You do want a diversified portfolio. So, the index provider has to put constraints on these indexes--and how they do the constraints, you have to really dig into it. I think, on some level, we don't really know what's going on. So, I think that's a risk.
Stipp: So, the important this is, no matter what kind of product you're using, look under the hood and see what your actual exposures are and see if you're comfortable with those exposures on a country and an industry basis, for instance.
Oey: Right. And then I'd also note that some index providers have these strategic-beta indexes with a lot of rules, and you actually see them kind of change their rules when their index isn't performing very well. So, that's also not good. It kind of reflects that they weren't thinking it through. You have to create an index that's going to work well over a whole cycle. Some of these indexes are quite young. They don't have a long track record. The market has been very strong in the last five years, but you need to think about how the index is going to perform over an entire cycle. Some of these things are very untested.
Stipp: Patty, some great food for thought for investors looking overseas to add exposure to their portfolios. Thanks for joining me.
Oey: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.