| Irish equities find favour in a balanced portfolio |
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| Robert Hegt suggests ways to ensure that investment strategies are balanced so that reward is reflective of risk. He finds that domestic equities are often a good ingredient for this and he believes that Irish equities do have a place in a global balanced portfolio. |
In constructing a benchmark for a global portfolio, we aim to find a combination of assets that maximises expected return for a given level of risk (or, alternatively, minimises risk for a required level of return). In doing this we take into account the characteristics of different asset classes and currencies.
Once an investor has an understanding of their own risk tolerance, taking into consideration their investment time horizon, we can then get to work on building a well-diversified portfolio that conforms to these parameters.
The ‘best’ ratio of the risk and return characteristics for all possible benchmark allocations is known as the ‘efficient frontier’. We have taken three imaginary investors at different points on the risk spectrum below, and built each of them a benchmark for a global portfolio based on our efficient frontier analysis.
We also show the probability of actually losing money through holding each mix of assets and markets, plus the potential reward from each portfolio over a three-year period. Investors with short time horizons would be wise to place more of their assets in lower risk assets such as cash and bonds. The expected returns are less, but so too is the risk of losing money. Conversely, the price of higher return is the higher risk of loss.
It makes sense for Irish investors to retain a bias to their home market - although we expect this necessity to diminish over time as Eurozone economies converge. In general terms, Eurozone investors should be taking an increasingly European sector-driven approach, rather than a top-down, country-driven approach.
The elimination of currency risk since the introduction of the euro, the break-down of trade barriers and the fact that companies are increasingly operating on a European, rather than domestic basis, means that Euroland investors should consider the wider picture.
However, right now, given that Ireland has one of the highest rates of inflation in Euroland, and the European Central Bank’s ‘one size fits all’ monetary policy, investors should consider hedging against this inflation by keeping around 40 per cent of their total European equity holdings in the Irish market.
In addition, movements in the Irish market have a relatively low correlation with other markets in the region. For example, over the last year, the Irish market has risen almost 30 per cent, which compares with an average fall in Euroland markets of approximately 12 per cent.
Of course, once you’ve decided on a strategic benchmark that maximises long-term returns for a given level of risk, you can then try to beat it by tactically overweighting areas in which you believe you can find the best shorter-term opportunities. For example, we think global equities will outperform global fixed income and cash in the coming months. Falling global interest rates are already allowing investors to look through some of the disappointing profits news and instead look forward to better times ahead. Interest rate cuts by the Federal Reserve and other central banks should lead to an economic pick up later this year.
The US equity market in particular offers some interesting opportunities. The Fed has acted swiftly in response to slowing economic growth, cutting interest rates to 4.0 per cent from 6.5 per cent at the beginning of this year. We expect rates to fall as low as 3 per cent by the time the summer is out. We believe these cuts should be sufficient to kick-start the economy, and given much better value in share prices than this time last year, we are optimistic.
The UK economy has held up relatively well over the last year and this has been reflected in market returns. However, the UK is more defensive and thus unlikely to benefit from a global turnaround to the same degree as markets which have seen a sharper economic slowdown.
We are neutral in Eurozone markets overall. While the Eurozone economy has not been immune to the global economic downturn, the European Central Bank’s decision to cut interest rates in May came as a welcome relief to most investors. We are monitoring our position in these markets and expect to buy into the region as leading economic indicators become more positive.
There are long-term reasons for investors in Eurozone equities to be positive. Increasing share ownership through pension reform and greater focus among European company management on rewarding their shareholders should support these markets in the longer-term.
Within the Eurozone, we are overweight in Ireland. However, this position does not result from country-driven asset allocation. It is simply that, from a bottom-up point of view, we can find a number of attractive investment opportunities among Irish companies.
Three Irish companies form a core part of our European portfolios. Pharmaceuticals company Elan develops treatments for Alzheimer’s disease, epilepsy, multiple sclerosis and Parkinson’s disease. Sales of its drugs are growing strongly. The shares look cheap compared to larger European competitors with more pedestrian growth rates. But there is no particular Irish angle in our decision to overweight Elan, as most of the company’s sales are in the US.
Another of our favoured Irish holdings, CRH, an acquisitive construction materials group, is a good example of a lowly valued cyclical stock. We are increasingly positioning our portfolios towards cyclical stocks given our view that interest rates will continue to fall and economic growth will pick up again later this year. However, our investment in CRH is not a play on the Irish economy: only 8 per cent of the company’s total sales are in Ireland.
However, we have invested in Bank of Ireland because of its domestic focus. A strong theme throughout our European portfolios is a bias towards smaller banks in strong economies with a primarily domestic exposure. Larger international banks are suffering from the global economic slowdown. Given the strength of the Irish economy, the Bank of Ireland looks a particularly attractive investment, especially given its reasonable valuation compared to the European banking sector as a whole.
We believe equity investors have plenty of reasons to be optimistic. They have had a difficult year and a half, but we are confident that we are coming up to a turning point in equity markets. History shows us that falling interest rates, combined with an improving outlook for economic growth, should result in positive returns for equity investors. |
Robert Hegt is head of European institutional business development at Schroder Investment Management Limited.
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| Article appeared in the June 2001 issue.
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