GLOBALISATION has become a major development over recent years. Companies have been encouraged to invest overseas, economies have become more open and the barriers to non-domestic investors have reduced. By and large, globalisation has been welcomed and UK companies and investment institutions have been in the vanguard of those seeking to exploit new opportunities.
Whereas this has been good news for companies, it may not be for investors because it is reducing the diversification benefits associated with some overseas investment. A different approach to portfolio planning may become necessary.
Globalisation is not a new phenomenon. The abolition of exchange controls from 1979 encouraged greater investment overseas, although even with controls, Britain had a long history of overseas investment. Perhaps the most significant development in recent years has been the increase in fixed direct investment by companies.
Although this was largely concentrated within the G7 economies during the 1980s, this has tended to be focused on the emerging economies during this decade. It is not difficult to see why. The demise of communism has tripled the size of the "free world" and unleashed new consumer markets. It has also led to a degree of competition unprecedented this century.
Consequently companies have needed to seek out lower costs of production and this has been facilitated in the economies of Asia, eastern Europe and Latin America. But globalisation is not just about investing in overseas markets. It also relates to how ideas circulate. The transmission of information and new technologies has never been so fast. The "knowledge intensive" industries of telecommunications, computer software, media, electronics and healthcare have produced emerging companies, some of which have set the standards for their field.
Microsoft and Intel come immediately to mind as companies that have set the agenda for others to follow. A wider range of dependent companies utilised these standards to build their own businesses. The integration process therefore gathered momentum.
This increase in geographical coverage and growth of truly global companies has increased the degree to which the main stock markets are correlated.
Although it might appear that Wall Street has deviated from the UK in recent years, the reality is that the correlations between London and a wide range of major equity markets has increased. Over the five years to June, the correlation between the US and the UK was still more than 50pc.
A high correlation between equity markets reduces the diversification benefits. The best combination of risk and return can be achieved through a portfolio that contains asset classes which are not highly correlated.
Hence the more these correlations increase, the lower the diversification benefits. Moreover, as it is unlikely that the process of globalisation will come to an abrupt halt, further reductions to these diversification benefits can be expected.
At the very least this should encourage long-term investors to re-examine the structure of their portfolios. Have they got too many eggs in the same basket? Have they got too many assets overseas? Are they in the appropriate areas?
There is no completely satisfactory guide to the optimal overseas exposure but I am inclined to the view that many funds have too many assets overseas. This conclusion is not simply based on the idea that as these funds are there to match domestic liabilities, a high domestic content is appropriate. It is influenced more by an extension of this thought process which maintains that you should invest overseas in the same proportion that you buy from there.
If 20pc to 25pc of our GDP is spent on imports, should we not invest an equivalent proportion to gain exposure to the profits of those companies selling to the UK? On this criterion, UK institutions are too heavily weighted in overseas assets, since recent surveys suggest that the proportion of UK pension scheme holdings of overseas equities and bonds exceeds 30pc.
These same surveys indicate that the proportion of UK equities is around 55pc. However, more than half the sales of the constituents of the FT-SE 100 share Index now come from overseas and this proportion is rising. Hence the total direct and indirect exposure to overseas economies is very high. Moreover given the typical spread of investments the diversification benefits are reducing.
There are two courses of action to remedy the situation. The first is to focus on diversification by industry rather than country. A well balanced portfolio of global industries may now be a more appropriate structure than one tailored by country classification.
The second course suggests increasing the proportion in UK equities. The London market now provides exposure to the most diversified spread of activities both geographically and across industries. It provides a more even balance between service sectors, general industrials, consumer goods, financials and utilities than five years ago.
The 100 share index now also provides significant sales exposure to Asian and Far Eastern economics as well as Continental Europe and North America. Given this greater diversification it would be appropriate for most funds to return home.
