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When is a domestic fund not a domestic fund? Back  
Emilio Gonzalez, chief investment officer of Perpetual Investments Australia, was in Dublin recently where he gave a presentation to the Society of Investment Analysts on Perpetual’s innovative approach to expanding the investment opportunity set for their domestic equity managers. Fiona Reddan reports from the seminar.
Perpetual Investments Australia, is one of Australia’s largest fund managers, with more than €16 billion in assets under management. In Australia, the firm is focused on the domestic market, and its portfolios are concentrated on Australian stocks.

In 2004, it established an Irish office, PI Investment Management Limited (PIIML), to run a global equities operation, and increase its exposure to the international market. This desire to rely less on Australian equities is also behind the company’s latest adventure – introducing international stocks into its domestic fund portfolios.

At a presentation hosted by the Society of Investment Analysts in Ireland (SIAI), Emilio Gonzalez, chief investment officer of Perpetual Investments Australia, enlightened the audience on Perpetual’s strategy.
There are a number of key factors behind Perpetual’s thought process:

1.) Globalisation: Pointing to the increasing globalisation of domestic stocks, Gonzalez said that the definition of what constitutes a domestic stock is blurring. He gave the example of ‘Australian’ stocks such as Henderson Group plc, Rinker Group and News Corporation, to illustrate this point, saying that the majority of these companies’ revenues come from abroad.

He said that international stock research was becoming more prevalent in domestic portfolios, and that when he was head of research with Perpetual, he introduced a system whereby each analyst covered an international stock, in order to increase awareness of the international market.

2.) Performance of Australian stocks: The other key factor behind Perpetual’s decision to expand its domestic fund to international stocks, is the firm’s belief that domestic stocks are trading at a premium to international stocks. (See Figure 1)

Gonzalez says that this is very concerning, and that in such a market, Perpetual is struggling to find value.
‘As a value investor, it hurts to continue to put money through a funnel,’ he said.

As such, at present, the firm’s domestic portfolio is more weighted to stocks which have significant international exposure.

So a combination of the above two factors, as well as the impact hedge funds, with their ability to short stocks, have had on the market, have led Perpetual to consider including international stocks in a domestic portfolio. In practice, this would mean that Perpetual might buy into Tesco, rather than Australian firm Woolworths.

On the other hand…
There are a number of arguments against such a strategy however, which Gonzalez highlighted.
1. Perpetual is a domestic manager
2. It messes around with asset allocation
3. What makes Perpetual think it can pick non-domestic stocks?
4. It would result in increasing currency risk
In response to the first issue, Gonzalez says that this isn’t an issue, as the benchmark for their funds doesn’t change – i.e. they will continue to be measured against domestic beta. As a result, there is no impact on strategic asset allocation, no change in risk profile, and no change in objectives of the fund.

Regarding strategic allocation, Gonzalez answered this by saying that this also isn’t an issue, as the benchmark and risk parameters will remain unchanged, and the allocation to international stocks will only be used opportunistically.

This approach, he says of expanding the breadth of Perpetual’s stock universe, will increase the potential of generating consistent Alpha.

Risk profile
Regarding the fund’s risk profile, Perpetual did some stress testing. Firstly,using the MSCI ex Australia, they took the largest, median, and smallest companies by market cap in each of the 10 GICS sectors in North America, Europe ex UK, UK, Asia Pacific and Japan.

They then appended each set of stocks to a domestic portfolio, and gave each group a weighting of 15 per cent, 20 per cent and 25 per cent respectively.

Perpetual also created a typical model portfolio of non-domestic stocks which you would expect to see over time, and these were added to the domestic portfolio with a 10% weighting. These portfolios were then loaded into the Barra Aegis risk model, and the UBS Portfolio Analytics system.

The team then found that the resulting tracking error was on a par with other domestic funds in the market.

The increased currency risk associated with introducing international stocks into the portfolio, was not as big as might have been expected said Gonzalez, as this already was a big issue for them, due to the presence of internationally focused stocks such as Henderson.

The response from the industry to Perpetual’s new approach has been very positive, Gonzalez said, to the point whereby one or two other domestic fund managers are now considering such an approach.
He says however, that it important to tell clients that it is not an allocation to international stocks, and that an allocation of 20-25 per cent to international stocks within the portfolio is the maximum.
Moreover, Perpetual will only pick international stocks which they think will out-perform domestic Australian stocks.

They have also factored in a valuation discount of around 10 per cent, as they say that information flows on international stocks would not be as good, as those on domestic stocks.

Joe Kavanagh, president of the Society of Investment Analysts in Ireland (SIA), afterwards told the audience that there was plenty of ‘food for thought’ in Gonzalez’ speech, and that it might be worth considering in an Irish context, due to the industry’s over-dependence on a number of key stocks.

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