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Follow-the-market not necessarily the best approach

Standard & Poor's Investment Consulting head Simon Ibbetson investigates the question: Should investors put their trust in the efficiency of global markets when looking to allocate their portfolio overseas?

Friday, April 28th 2006, 6:58AM
The answer depends on their reasons for investing offshore, according to Standard & Poor's Investment Consulting.

Investors with a strong belief in the efficiency of markets, and wishing only to outperform the "balanced manager" might do best with a "follow the market" approach.

Investors with an absolute return focus, a longer time horizon/higher risk appetite, or, in particular, a need for diversification might find it timely to consider some rebalancing.

Standard & Poor's has long advocated increased exposure to global markets in order to enhance returns or reduce risk, but primarily to increase portfolio diversification.

However, like any investment decision, when looking offshore investors need to decide whether to follow the market or try a different approach.

For those who opt to follow the market, the starting point in most cases will be a market capitalisation-weighted benchmark. Such a benchmark is based on the assumption that efficient markets will allocate money to the most productive regions, countries, sectors, and stocks.

"Using a market-cap approach is an attractive option for most investors, particularly those without the resources or time to fully research global markets," according to Simon Ibbetson, head of Standard & Poor's Investment Consulting.

"Knowingly or otherwise, most people follow this approach when investing in international equities. For example, most mainstream managers allow within 5%-10% of the regional allocation of the S&P/Citigroup global index. This mental short-cut has served investors well over the past two decades, as the largest constituent, U.S. equities, has helped drive global markets upward."

"However, successful strategies are often the victim of their own success. Market-weighted indices can develop strong and sometimes unwanted biases at a regional, country, or stock level," Ibbetson says.

"At some point, such concentration can significantly affect portfolio diversification or run contrary to an investor's view of the world. Whether this requires any mitigating action will depend on the priorities of the individual investor."

Investors with an absolute return focus, a higher risk appetite, or seeking diversification would be the most likely to benefit from a review of their offshore allocation.

According to Ibbetson, the risk of "being left out" of a bull market that is led by the largest elements of the index is less now than, say, in the early 1990s, and therefore now may be an appropriate time for investors to consider some rebalancing.

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