Question

alian share market has been punching above its weight in recent years, leaving Australians with little need to look overseas for investment opportunities. But all prize-fighters have their day, and while the outlook for both Australian and international shares is uncertain, it makes sense to spread your risk and wage a small bet on global equities. For most people, the easiest way to do this is to invest in an international equity fund.

In the 12 months to May 31 when the Australian market returned 23.5 percent and global equities (measured by the MSCI World Index) returned 4.8 percent, the top 10 international

funds returned more than 12 percent. Over three years, which is a more reliable measure of fund performance, seven of the 10 convincingly outperformed world markets, which fell 2.5 percent.

Most pundits expect the returns from Australian shares to be more muted over the next 12 months, encouraging professional investors to take a closer look at the alternatives. A recent survey of 43 investment managers by Russell Investment Group found that most believe international equities will be the strongest performer over the next 12 months.

A market veteran and independent consultant, Don Stammer, insists the "investment arithmetic" for global equity markets is not stretched. Overseas markets have recovered from their low of 2003 but they have not climbed to record levels, as Australian shares have. He believes share valuations are comfortable rather than stretched, in Australia as well in the US and Asia. Stammer considers the big risk to global markets over the next 12 months is unpredictable events in the Middle East. "The biggest unknowable is exchange rates," he says.

"Unforecastable" is how Hans Kunnen, the head of investment markets research at Colonial First State, describes the Australian dollar, but he agrees that much depends on it. If commodity prices hold up then the Aussie dollar should do too, but if the US increases interest rates, attracting global capital away from competing currencies, then our dollar could come under pressure. Because of this exchange rate uncertainty and the fact further rises in the Aussie dollar will reduce returns of global funds when they are converted back into Australian currency, Stammer says it is important to choose a fund that can hedge.

The importance of hedging in the current market is demonstrated by the dominance of hedged funds in the accompanying table. While the fully hedged version of Invesco's Global Matrix Fund was up almost 19 percent, the unhedged version - which is identical in every other way - returned 11 percent.

In terms of regional markets, Stammer has a slight bias to Asia with the exception of China. He believes the scheduled tightening of monetary policy in the US is factored into the market, while in Europe, he says, companies are performing better than economies. Kunnen points out that despite all the talk about China, its share market fell 25 percent over the past 12 months and compares this with India, where shares rose 50 percent. "This highlights the volatility in emerging markets; investors need to be wary," he says.

Kunnen says the US is showing good resilience, Japan is showing signs of life and he is neutral on Europe, although he observes that European companies are doing well by focusing on export markets and cutting costs. This is borne out by Equity Trustees's Intrinsic Value Fund, one of last year's star performers, which invested almost exclusively in European markets.

It's possible to buy funds that focus on a region or a global industry sector such as biotechnology or listed property, but for a core international shareholding it makes sense to begin with a diversified fund with the ability to invest across a range of markets and sectors. Even then, there are choices to make. No one style of fund prevailed last year. The top two funds are globally diversified but they were followed by two resources funds, reflecting the global commodities boom.

Index funds, which passively track a market index rather than actively pick stocks, also held their own, with four in the top 10. With fees significantly lower than their hyperactive rivals..., they continue to offer value for money.’

Questions:

1. Explain the logic behind investing in international share funds as against only

investing in domestic stocks.

2. Outline why it is important for firms to hedge their exposure.

3. Explain the approach of index funds and its advantage.

Australian

Answer 1

Answer(1): Investing in international share funds as against only investing in domestic stocks

Investing into international share funds give us following advantages that we cannot get in investing only into domestic stocks:

1. When you invest into international funds, you diversify your portfolio, you get chance to invest into different stocks of different sectors, your portfolio is balanced as if few stocks are doing well and other stocks or sectors are doing well, it will manage your portfolio in efficient manner. Risk is diversified when you invest into different sectors. You are not directly exposed to a particular market, sector or stock.
2. Investing into international funds give you growth, capital appreciation and higher returns.
3. Investing internationally provides you security, safety and confidentiality of your investment. International investments are entitled to more freedom, they do not present or disclose your investment to the Government directly.
4. Currency diversification gives you benefit if you invest into a country whose current is stronger than U.S Dollar.
5. Many countries provide attractive tax benefits to foreign investors. Countries do so to attract more foreign wealth.

You cannot reap the above said benefits while investing into domestic stocks only.

Answer(2): Hedging- It is a technique of mitigating risk. It is done with the help of financial derivatives that includes, forward, futures, options, swaps etc.

Companies that operate internationally, must hedge their exposure, companies hedge their exposure because of the following reasons:

1. Companies who operate internationally, directly expose to currency and interest rate risk, their cash flows and income are affected by the fluctuations in currency and interest rate due to change in economy or politics. Companies have to hedge against exchange rate risk so as to save from losses.
2. Hedging provides an insurance against the profit erosion, that is good for the firms, operating on tight margins. It locks in the future profit by locking or fixing the prices.
3. Hedging techniques can be done with the help of forward and futures, companies get advantage of customized and standardized contracts. Companies can enter into hedging as per their own capacity and wish.

Answer(3): Index funds- Index is a barometer of overall market. Index fund is a mutual fund that tracks the performance of a particular index. There are many indices in the world. In U.S, S&P 500 and DJIA are main indices. It provides you basket of stocks.

Examples of index funds: Are as following-

• Vanguard 500 index fund investor shares
• Fidelity 500 index fund
• Schwab S&P 500 index fund
• T.Rowe price equity index 500 fund

Advantage of Index funds- Are as following:

• It provides benefit of risk diversification, If you invest into a fund that tracks performance of S&P 500, it has 500 different stocks of different sectors, you money is diversified so as the risk and you get better returns.
• It provides low operating expenses and a broader market exposure. Expense ratio of Vanguard 500 index fund is just .20% that is on an average 1.12% of other actively managed funds.
• Once Warren buffet said, Index fund is the most lucrative fund for retirement, instead of investing into different stocks, invest into index fund for long term and you will be surprised to see the returns.
• Index funds have lower turnover so they are tax efficient.