How to build up a global portfolio

If you are an individual investor who would like to diversify internationally, to reduce the risk in your portfolio and hopefully improve your returns over time what assets should you select?

Here are some ideas drawn from various sources over my quarter-century of writing on the subject

Index tracking

If you believe a return at or close to the market average is the best you can hope for, your best approach to global asset allocation is a passive investment programme replicating market indexes, using exchange-traded funds (ETFs).

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Although index-tracking strategies have somewhat fallen out of favour recently, the world's most famous investor, Warren Buffett, argues that they're fine for ordinary folk who don't have the knowledge and skills to manage their equity portfolios well.

Others argue that in bear markets especially if you believe that we're in a long-term bear trend the sensible way to invest in shares is "stock picking," or selecting the companies or funds that can gain in value against the trend. The trouble with that is that it's hard to do. Either you have to have the knowledge, skills and time to do it yourself. Or you accept the "fund manager risk" the risk of selecting managers who get it wrong. Usually those with a good track record that turns sour just when you commit your money to them!

As an alternative to the handful of investment funds that truly mirror a global index, you can construct your own portfolio out of a selection of regional funds, or those that track single country indexes, using ETFs (exchange traded funds), investment trusts (closed end funds, also listed on stock exchanges) or mutual funds (unit trusts).

The most important argument against trackers is that they channel your investment towards overvalued shares rather than undervalued ones. The most powerful objection to the alternative, actively-managed funds, is that in practice they are rarely able to match - let alone beat - the performance of trackers over the long term, and identifying the few exceptions in advance is very difficult.

Past performance is of little value

For smaller investors, collective funds are the only practicable way to go global. But how do you select ones for your portfolio?

With international, as with domestic, funds, investors have come to realize that past performance is no reliable guide to future returns. A fund may look good over periods such as one, three or even five years just because it had one sensational year. It may have done well in recent years only because market fundamentals or fashions have favoured its particular investment style which is on the verge of going out of favour.

But one kind of past performance does seem to foreshadow the future poor performance tends to continue.

By choosing a particular category, benchmark and/or time period, managers of a fund may be able to present its performance as having been excellent. That's why it's important to look at consistency of returns.

Questions to ask

If a fund looks good on that basis, discover how the consistently high returns were obtained. Was it luck or judgement? Is the performance repeatable? Has the strategy been high- or low-risk?

Experts suggest you should also ask: "What is the most money I could have lost in this fund if I had bought and sold it at the worst time?" That gives you a measure of downside risk.

Does the fund you have in mind really do what it claims to do? Some of the funds investing in shares in China were discovered to be very high risk venture capital providers. Others, more reputable, actually have much of their funds invested in Hong Kong and/or Taiwan, which is not quite what most investors have in mind when they go into a "China" fund.

An American study showed that some funds were able to improve their benchmark-adjusted returns by nearly 1% by switching categories at the end of the year, so they could be measured by benchmarks that showed them in the best light. So take a look at the detailed composition of a fund's portfolio and see how it compared to its claimed investment approach.

Evaluating managers

How much did the past performance of the fund depend on one person rather than a cohesive team of clever investors?

There is a surprisingly high turnover of managers, so the one who racked up the impressive gains may have been poached by a rival firm. Finding out who will really decide where your money goes can be difficult, especially as some fund groups don't want their managers to become too well known.

But if you can, discover who's The Man, how long he's been with the fund, what his overall track record has been, and whether his style matches your investment objectives or whether it has changed recently.

Letters to shareholders often help as they tend to be written by the managers themselves, rather than by PR hacks. Such letters generally offer a fairly candid view of what has gone right with the fund and what has not. Ask the fund management company for copies of published interviews with the manager.

The aim of all this detective work is to differentiate between luck and skill, to discover which part of a fund's returns is due to markets, which to investment style, and which to stock-picking skills.

Do managers really matter that much? An American study by CDA/Wiesenberger of 40 equity funds found that the top performers fell to 10% below the norm in the five-year period after their managers left. Conversely, the study showed that returns from poor performers soared from 69% below the norm to 27% above average in the five years after a new investment manager was hired.

Find the local hero

A simple way to find the right manager for a country fund is to go with the best of the indigenous funds, some experts suggest.

One study by a firm of performance measurement experts showed that the best returns among funds investing in a single country will generally be scored by local, rather than foreign, managers. Not surprising, I suppose. Over a three-year period local mutual funds' returns outperformed those of foreign-registered funds by achieving an average 40% versus 29% return in Swiss shares, 39 to 27% in British shares, 15 to 9% in Germany and 10 to 1% in France.

So you're likely to do best by picking a local team if there's one you can invest in to manage a single-country fund.

Group style

Don't just look at the fund look at the group as a whole. If it's posted solid performances in its other funds, that's a plus.

Individual funds can have a great run for a while because they're invested in a particular country that's currently top of the pops. But for the long haul, your best chance of achieving decent returns is to invest in several country or regional funds run by one, two or three management companies with the best all-round and consistent performance. There is the added advantage of reduced costs should you decide to switch funds within a group.

Keep down expenses

Given equal risk-adjusted performance, a fund with a low expense ratio stacks the odds in your favour.

This factor favours, in order of priority: no-load funds (generally only available in the US), exchange traded funds and investment trusts whose shares are listed on a stock exchange, then load funds such as unit trusts. Load funds are those that take an up-front charge, so don't invest the full amount of your capital. A study by the US financial magazine Forbes showed that on average there was no difference in performance between load and no-load funds.

Go 'offshore'

Offshore funds offer advantages over onshore funds in that they don't deduct tax for any revenue authority before distributing income or gains to you, have greater freedom in the ways they invest, and offer greater client confidentiality. The downsides are that their charges are usually higher, they often lack sufficient transparency, and you enjoy less investor protection if things go wrong.

The term "offshore" applies to funds based on islands, such as Jersey, the Isle of Man, Bermuda, but also to funds in landlocked countries such as Luxembourg and Switzerland marketed to non-residents.

Fund managers, bankers and trust companies based "offshore" do not normally disclose an investor's holdings to any third party. However, because of increasingly aggressive activity by governments to combat tax evasion, money laundering and financing of terrorism, they will often do so to investigative agencies that produce the correct paperwork. Switzerland, under extreme pressure from the US, is loosening its traditional secrecy by finding new ways to interpret old laws protecting investor confidentiality.

Keep it simple

Using one fund family makes for trouble-free management, which encourages you to do your periodic portfolio reviews. It also "brings you many conveniences, such as toll-free telephone switching, consolidated monthly statements and an annual consolidated tax statement," says one adviser.

Firms such as Vanguard (US-based) and Robeco (Europe-based) "have all the tools needed to build a first-class, globally-diversified, low-cost asset allocation plan within their fund families. They'll even show you how their funds can help you index nearly the whole world's tradeable economies."

If you wish to diversify beyond one group, you can keep things simple by using one discount brokerage house that gives you access to hundreds of funds with the convenience of a single account. "You can avoid initial purchase charges on existing funds or stocks you wish to keep by transferring title to your discount brokerage account. The transfer may take weeks to clear, but should mean tidy cost savings."

Be careful to avoid funds with frequent turnover of their holdings, steep expenses and high minimum investments or yearly charges. Money taken in charges is loss of capital that would otherwise be invested in growth.

Don't be dazzled by new funds

Most of them are just virtual clones of existing ones, or currently fashionable ideas that are almost certain to disappoint. However, occasionally something new and really useful becomes available, such as the ETFs offering direct investment in gold, oil and uranium, or single-country funds providing a convenient way to invest in a smaller emerging market or business sector.

Investing directly in shares

Exactly the same principles apply internationally as they do in your home market. You need to do a lot of homework before committing your money. Unless you value the advice and research you get from stockbrokers, use discount brokerages.

Earnings expectations are an important determinant of share prices. You can track analysts' forecasts and how they are changing for thousands of companies worldwide by subscribing to the IBES system, but it's far too expensive for individual investors.

Avoid heavy brokerage costs by opening an account within any country in which you want to invest directly in shares. It's easy to do. Deal with the biggest bank, so there's no risk it will go bankrupt. They'll keep your certificates, collect your dividends, and reinvest if you wish.

This article was written by Martin Spring in On Target, a private newsletter on investment and global strategy. Email Afrodyn@aol.com to be included on the recipient list.