Investment Matters

International Equities: a cosmopolitan tilt

Over the past two weeks, some changes have been made to your International Shares sub-portfolio.

Clients’ allocation to International Shares had previously been invested in a single fund to provide a broad exposure to the world’s largest companies in major developed countries.

Earlier in the year we took advantage of a lower AUD/USD exchange rate to lock in up to half of our exposure at those levels.

Over the past year the underlying exposure within these funds become more concentrated. There have been two reasons for this: the rapid rise we have seen in the US Technology Sector and size weighting to US markets overall.

Recently, we have begun lowering your allocation to US shares, with a focus on reducing exposure to the big 5 technology stocks (Apple, Amazon, Google, Microsoft and Facebook), which have risen rapidly over the past year. This allocation will be reinvested in countries where we see more value, specifically Japan and in Europe.

We explore these factors that led to this concentration and the changes we have made in response.

When size matters

Size weighting is a term which describes the weighting of companies in a portfolio in proportion to their size (or market capitalisation in dollars).

Practically speaking, this means that larger companies receive a higher weighting and smaller companies receive a smaller weighting.

Readers will be familiar with the impact this has had on the All Ordinaries Index – where approximately 20% of the Index is represented by Banks. As we can see below, this is a function of their size relative to the broader Australian Share market:

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The weighting of companies by size has had a similar impact on your International Equities allocation.

However, this impact can be viewed in two dimensions.

The first is company exposure. Much like above, the largest international companies on a global level have a higher representative weighting.
The second is country exposure. Another consequence of size weighting is that countries larger share markets have a higher representation than countries with smaller markets.

The FAANGs: a concentrated anti-serum

Over the past six months technology stocks have almost single-handedly propelled the S&P500. This is a topic we have covered ad nauseam, but the resulting divergence in performance between the US market (particularly the NASDAQ) and the rest of the world remains worth highlighting. While the Nasdaq is 20% higher than where it began early in the year, much of the word’s markets are yet to recover.

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The exposure to companies within the NASDAQ has benefited the performance of your International sub-portfolio over this period. From a holistic perspective, this exposure has also bolstered your portfolio’s overall exposure to the Technology Sector, through global, quality names.

However, it has also resulted in your international exposure becoming more Ameri-centric. As at the 30th of September, your exposure to US companies was approximately 3% higher than it was at the beginning of the year.

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Much of the rise can be attributed to the five largest technology stocks: Amazon, Google, Facebook, Microsoft and Apple.

As a result, your international exposure had become much more concentrated in this handful of names – with a 15% exposure to these 5 stocks.

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Added to this is our concern that the share prices of these companies have run too hard. They remain fantastic businesses, however in the face of demanding prices and rising regulatory risk, we see that better value is likely to be found elsewhere.

The recent run up in prices is exemplified by shares in Apple. The chart below shows the increasing disconnect we have seen between operating performance (as represented by the gold line – EBITDA – representing operating profit) and prices paid (as represented by the blue line – Market Capitalisation). The increasing disconnect demonstrates investors have been willing to pay more for the promise of future earnings.

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Active management: a cosmopolitan tilt

Responding to this, we implemented a “cosmopolitan tilt” to your portfolio this week.

We describe the changes as a “tilt” because they are relatively small but have the potential to meaningfully improve performance. 

Firstly, we have looked to reduce the allocation to these big 5 technology stocks by approximately 30%. 

In doing so we have diversified your holding in US shares with more mid-sized companies. This is through a holding in iShares Mid-Cap ETF (IJH.AXW).

This has also modestly reduced your overall exposure to US stocks.

In place of this, we have added to your exposure to European (+24%) and Japanese stocks (+32%). 

This is through holdings in iShares MSCI Japan ETF (IJP.AXW) and iShares European ETF (IEU.AXW).

The result can be seen below:

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We see this as providing better value at the margin, as well as providing more exposure to markets that are likely to see an outsized benefit with a recovery and improvement in nominal activity globally.

This provides more potential to enhance the strong returns and outperformance we have seen to date, in the same vein as the decision to hedge your currency exposure earlier in the year.