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Innocents Abroad: Currencies and International Stock Returns

Innocents Abroad: Currencies and International Stock Returns. Agenda. Background and Meyer’s Philosophy Why Invest Internationally? Convincing the Client Calculations and Interpretation Optimal Portfolio. Case Background. Sandra Meyer : Founder of CapGlobal Advisors, LLC.

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Innocents Abroad: Currencies and International Stock Returns

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  1. Innocents Abroad: Currencies and International Stock Returns

  2. Agenda • Background and Meyer’s Philosophy • Why Invest Internationally? • Convincing the Client • Calculations and Interpretation • Optimal Portfolio

  3. Case Background • Sandra Meyer: Founder of CapGlobal Advisors, LLC. • CapGlobal Advisors,LLC. • Seven professionals focused in different areas of international portfolio management • Methodology focused on quantitative modeling and extensive researchon international markets • Henry Bosse: CIO of the local state pension fund • Client Concerns about International Strategy • Might not really add much value to overall portfolio • Might create unnecessary currency risks

  4. Case Background • Difficulty: hard to sustain investors’ attention in international stocks. • When domestic market performs well; why they were not fully invested in U.S.? • When domestic markets sink; why gains of their foreign exposures were often not large enough? • Mission: • The benefits of international diversification • The impact of currency movements on returns of global portfolios • The drivers and consequences of correlations among global equity markets

  5. Meyer’s Philosophy Investing Internationally Adds Value to a Portfolio • International diversification enhanced the returns that were possible for a domestic investor • International market returns can be achieved through both currency movements and equity performance

  6. Indices • Domestic Index • S&P 500 • International Indices • EAFE • Morgan Stanley Capital’s Europe, Australasia, and Far East Index • EM • MSCI Emerging Market Index

  7. Why Invest Internationally? • Increased expected returns and decreased standard deviation • International stocks are just one of the five main asset classes and each respond different to market cycles and events • others are large-cap stocks, small-cap stocks, bonds, and cash investments • Increased exposure to more companies with unique products and customer sets • Added diversification with multiple currencies • International stocks are becoming a larger share of the investment universe • Weather upturns and downturns differently

  8. Why Invest Internationally? • Boost returns with unique and emerging markets and currency variety Unique: growth opportunities not available in the US • Can be due to differences in household income, younger populations, export strength, availability of natural resources, etc. Emerging: developing countries experiencing rapid growth and industrialization • Higher expected growth rates = higher potential returns • Lower household income and lower debt levels allow for faster growth • Higher risk alone, lower risk for portfolio due to diversification • China, India, Brazil, and Russia

  9. Why Invest Internationally? Currency: currencies move relative to other currencies • Adds a layer of diversification because currencies move in different directions at different rates • For greatest diversification benefit, exposure to international equities should be unhedged • When the US dollar declines, investments in other currencies may boost returns; reverse is also true • Examples

  10. Currency Examples December 1998: Nikkei fell 4.43%, Yen appreciated against USD 8.56%, net return of 4.14% to US investors March 2001: Nikkei has 3.8% equity return, Yen depreciated against USD 6.8%, return more than eliminated

  11. Looking Forward • IMF forecasts US growth at below the world growth in coming years • US’s importance and share of world economy has been declining as emerging markets have grown in size Meyer also sees the growth opportunities: • EAFE and EM returns versus S&P 500 returns in 1993 • EAFE > S&P 500 by 22.82 points • EM > S&P 500 by 28.86

  12. Convincing the Client • US equities have generally outperformed other developed country equities • Familiarity with domestic companies and markets • Easier to focus on only one market • Emerging market equities are highly volatile

  13. Exhibit 1 Index Returns for the EAFE, EM and S&P 500 (in Native Currency) from 1991 to 2013

  14. Convincing the Client • Alone, international investments are more risky due to added currency risk • Returns shown by foreign indices are a combination of currency risk and equity risk which can be misleading • Meyer must • convince clients of the benefits of international diversification • highlight the impact of currency movements on returns of global portfolios • explain the drivers and consequences of correlations among global equity markets

  15. Meyer’s Process • Examine international equity performance over a considerable time frame: 1991-2013 • Calculate monthly returns for the markets: Australia, Canada, China, Germany, India, Japan, United Kingdom, and United States • Compare the returns and calculate average monthly returns and standard deviations in 10 and 11 year sub-periods • Annualize all returns and standard deviations

  16. Meyer’s Process 5. Calculated correlations of returns based on local currency and USD (for 1991-2013, 1991-2001, and 2002-2013) 6. Decomposition of Foreign Stock Market Returns to U.S. Investors relative to the S&P 500 into returns based on equity and returns based on currency 7. Allocate return foreign equity and foreign currency by comparing returns based on the EAFE and EM indices with the S&P 500

  17. Results of Returns and Standard Deviations For Returns • Low • Medium • High Native Currency Based Annualized Returns and Standard Deviations over 1991-2013, 1991-2001 and 2002-2013 For S.D. • High • Medium • Low U.S. Dollar Based Annualized Returns and Standard Deviations over 1991-2013, 1991-2001 and 2002-2013

  18. Correlation Table of Native Currency Based Returns 1991-2013 • Low • Medium • High 1991-2001 2002-2013

  19. Correlation Table of Dollar Based Returns 1991-2013 • Low • Medium • High 1991-2001 2002-2013

  20. Decomposition of Foreign Stock Market Returns to U.S. Investors relative to the S&P 500 Table A EM Returns to U.S. Investors Relative to the S&P 500: Contribution by Foreign Equity Returns and Foreign Currency Returns in 1991

  21. Calculating Figures

  22. Calculating Figures

  23. International Diversification - Yes or No? • In most cases international diversification reduces risk • Taking currency movements into consideration is crucial • The assumption that riskier investments yield higher returns is not true in this case

  24. Efficient Frontier Basics • Investors • Non-satiation: better returns • Rational: logical decisions • Risk aversion: compensation for risk • Mean-variance: decisions based on only return and risk • Results • Minimize risk for a given expected return • Maximize return for a given risk • “Efficient” • When there is no other asset or portfolio that offers a higher expected return with the same (or a lower) risk • Upper half of the curve: above the minimum variance portfolio on the portfolio frontier

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