However, we also pointed out these investors may be missing out on better value and growth opportunities not readily available on ASX, whilst achieving better portfolio diversification, leading to a more sustainable risk/return profile.
Australian Economy and Sharemarket Highly Concentrated
Despite talk of the Australian economy’s transition from a resources-based economy to a services-based economy, the fact remains merchandise exports (i.e. physical products such as commodities and goods) account for between 75% to 80% of Australia’s exports, while services make up the rest; and this level hasn’t changed much in the past 20 or so years.
While there has been a concerted effort to grow the exportation of services such as financial services and education, there has been limited success to date, meaning the broader services economy in Australia are predominantly driven by domestic demand.
In the meantime, Australia’s manufacturing capabilities have declined; a result of increasing globalisation, rising currency and diminishing scale. And while this capability has been replaced somewhat by growth in infrastructure, housing and construction, their demand remains almost entirely domestically driven. Australia’s economic prosperity remains leveraged to consumption-based growth, driven by household spending, in an environment of low wage growth and high house prices. The preoccupation with home ownership has resulted in household debt-to-income ratio hitting a record high of 189%, according to the Reserve Bank of Australia, making the Australian economy one of the most leveraged in the world, with household debt now worth more than Australia’s total economic output.
Strong Case for Diversification
International equities can help reduce overall portfolio risk through more effective diversification, without having to divert funds away from growth assets. A diversified portfolio means that losses in certain investments within your portfolio could be offset by gains in other areas. Given these benefits an allocation to international equities could suit a wide range of investors such as those looking for capital growth ahead of retirement, or those looking to deploy their cash holdings into growth assets.
The key benefits of investing in international equities are as follows;
Reducing Country Specific Risk
The Australian sharemarket mirrors the domestic economy in being highly concentrated, as it is dominated by two sectors; financials and resources, which together account for over half of the Australian market by value, compared to less than a quarter for global markets.
Financials and resources are both essentially cyclical in nature, which means they tend to be strong performers at the beginning of an economic recovery, in part because their financial performance tends to be more economically leveraged however they become vulnerable as the economy heads into recession.
This level of concentration risk in the Australian economy potentially leaves the market vulnerable to a country-specific shock, for example a burst housing bubble, and the likely flow on effects into the banks first, and then into the broader economy, with obvious implications for the sharemarket. This leaves investors with Australian assets highly exposed to the Australian market and business cycle. By investing internationally, thereby reducing your exposure to Australian assets, you can reduce the impact of a shock on your portfolio.
Australia Over-exposed to Financials and Materials
Correlation, in the finance and investment industry, is a statistic that measures the degree to which two financial assets move in relation to each other. We find Australian equities have a low correlation with International equities given they are impacted by a much broader and different set of economic factors.
Another factor is the Australian dollar, which has traditionally acted as a “risk” currency, rising during buoyant global economic conditions and coming under pressure when sentiment dips. This means a fall in global equities due to weaker economic conditions tends to be offset by a weakening Australian dollar, providing somewhat of a hedge on the values when translated back into Australian dollars, reducing the volatility of global equity returns for Australian investors.
Fear of Missing Out
The Australian sharemarket represents only about 2 per cent of the world’s sharemarket capitalisation, and while there are a number of companies listed on the ASX with exposure to global markets, most Australian investors may be missing out on some of the world’s most attractive and dynamic investment opportunities.
These opportunities can take the form of exposure to developed markets such as the US and Europe which provide access to a broader range of sectors and some of the world’s largest and most successful companies. They include fast-growing sectors that are yet to reach full maturity, and sectors with very different growth profiles to those which dominate in Australia.
Opportunities available in international markets include sectors and companies where Australia is under-represented such as technology (Alphabet/Google, Facebook, Twitter), healthcare (Johnson & Johnson, Novartis, Pfizer) consumer brands (Nike, Apple, Nestle) and specialist manufacturing (Boeing, Schindler, Rolls-Royce).
Emerging Markets Can't be Ignored
Exposure to Emerging Markets
Investing in international equities will allow you to take advantage of the growth in developing economies via emerging markets in Asia, Latin America and Africa, with their favourable demographics and high economic growth. While investing directly in emerging markets is higher risk, there are ways to obtain exposure such as companies listed in the Australian, US or European markets but with their major growth driver being their exposure to emerging markets.
Over the last few decades, there has been a shift in the global economic gravity from the mature economies of Europe and North America and towards the fast-growing Asia-Pacific region. As the Asian economies move away from capital investment towards consumption as the main driver of economic growth, other sectors are likely to become increasingly important. Already, companies around the world are scrambling to service growing demand from the rising Asian middle class, including demand for food, beverages, clothing and consumer goods.
As an example the VanEck MSCI World ex Australia Quality ETF trades on the ASX under the code QUAL. Through purchasing units in this ETF, investors are buying a basket of 300 high quality companies from 19 countries around the world including North America, Europe and Asia.
- QUAL is an ASX-listed ETF that provides investors with exposure to 300 quality companies from around the world.
- The companies are included in the portfolio based on; high ROE, stable earnings growth and low financial leverage.
- The portfolio has sizable exposure to sectors such as IT/healthcare and is underweight Financials.
- Exposure to 19 countries in North America, Europe and Asia.
- The fund is unhedged giving investors exposure to the underlying currencies of the various companies (predominately US$).
- QUAL is listed on the ASX and trades under the code QUAL.AXW – there is no W8-BEN or other foreign paperwork required.
- Administrative efficiency of a single ASX trade to access a basket of companies from around the world.
A Lower Yield, but Potentially Better Growth
Traditionally, international equities have offered a lower dividend yield than investors in Australia may be accustomed to from their Australian shares. International dividend yields have typically been around 2%, while Australian equities tend to yield closer to double that, even before considering franking credits.
U.S. companies tend to retain more earnings to reinvest in the business, while using share buybacks to return extra capital to shareholders rather than via a high regular dividend. The fact is many industry-leading companies have been growing their dividends consistently over decades and buying back their shares, even during the GFC, leading to growth in both income and capital.
In the current environment of low global growth and cashheavy balance sheets, there is pressure on companies to undertake further share buybacks or increase dividends, which may ultimately lead to higher payout ratios.
Differing Valuations Create Opportunities
Given the differences in national economic and market cycles, and the variations in valuations across markets, there are times when international equities offer significantly better value than other asset classes, including Australian shares.
Variations in Global Equity Valuations
(Price to Book Ratio)
Obstacles to Investing Internationally
Given all of the potential benefits of diversifying offshore, it is surprising so few Australian investors invest internationally. It may be investors are discouraged by the complexities and costs in selecting and administering investments on unfamiliar overseas markets, while managing tax and foreign exchange across multiple jurisdictions.
The complexities vary by the type of investments undertaken however they are not significantly higher than those required for opening an Australian share trading account and maintaining a record of dividends and capital gains. In the case of direct international share investments, any new or existing clients who have not previously held international shares need only to complete the appropriate W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting) and an International Client Application form.
Accessing International Equities
Australian investors have a range of options for accessing international equities and common approaches include:
Direct Equity Investments. Offer relatively low brokerage and holding costs while retaining complete control over your investment, although with that control comes the responsibility to administer your holdings and manage currency movements and potential tax issues.
Managed Funds. Many retail managed international funds offer the benefits of active management and instant diversification but typically have significantly higher management costs than their domestically-focused peers, making this option less attractive to many investors.
- Chess Depositary Receipts. Depositary receipts are currently only issued over a handful of dual-listed stocks on the ASX. However, there are moves to incorporate depositary receipts over the shares of companies listed on NYSE and Nasdaq, allowing Australian investors to own global blue chip companies, like Apple and Facebook, traded in Australian dollars, during Australian market hours, receive Australian dollar dividends and held in CHESS.
- Exchange Traded Funds (ETFs). ASX-listed International ETFs can be attractive in accessing the benefits of international diversification while avoiding some of the administrative complexities (W-8BEN not required for some ETFs) as well as the high costs of managed funds. ETFs are a passive style of investing which provide investors with exposure to international, regional, country or sector indices. ETFs seek to track the performance of these indices and can either be held as a core exposure to international equities in your portfolio or in combination with direct investments and managed funds.