Going Global: How Many Funds Do I Need?

Should you simply buy a single global-focussed fund or build your portfolio using various specialist regional funds?

Alastair Kellett 23 July, 2012 | 3:59PM
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One of the questions investors face when building their portfolio is how granular to get when setting their asset mix. For some, a hands-off approach that uses a single fund may suffice; others will want to put their portfolio together piece by piece, adding or reducing a little here and there to fit their market views. It’s worth considering the pros and cons of each strategy, and taking a look at how the underlying characteristics of the portfolio might differ in each case.

MSCI World Index vs. Piecemeal Approach
For this exercise, we’ll make a comparison between having an exposure to the MSCI World Index, on the one hand, and on the other hand a collection of more geographically-focused indices. The latter, our home-made basket of funds, is not designed to resemble the MSCI World, nor to provide exhaustive coverage of the globe. It’s simply a naive construction based on how a reasonable person might build a global portfolio using a handful of indices. It consists of the following:

- 30% S&P 500
- 20% EURO STOXX 50
- 10% FTSE 100
- 10% FTSE China 25
- 10% MSCI EM Latin America 10/40
- 10% MSCI Japan
- 10% MSCI Pacific ex-Japan

The first thing to note is that the two portfolios are, in fact, different. Because of the way that different indices are set up, exposures that sound the same or purport to cover the same parts of the market can look and perform differently. In this case, our geographic mix is fairly divergent. Here are the top 10 regional exposures for each, as of the end of June:

These differences can have important implications for long-term performance, as each country will have some idiosyncratic risk associated with its equity sector makeup, largest companies, political situation, currency, etc. One obvious distinction between the two portfolios is that our constructed basket contains emerging markets exposure, whereas the MSCI World Index includes only developed market equities. This distinction may result in our hypothetical portfolio being a little more volatile over time. The two also occupy somewhat different spots in the Morningstar Style Box. Relative to the MSCI World Index, the hypothetical portfolio is a little more tilted towards larger cap names, and towards the value end of the spectrum. From an equity sector perspective, the hypothetical portfolio has considerably more Financials exposure, at 21.7% versus 18.6%, and is less exposed to Information Technology and Healthcare.

The historical returns of the two portfolios have been correlated to a degree of 98%, although the hypothetical basket has outshone the MSCI World Index. Assuming semi-annual rebalancing, the hypothetical portfolio has a trailing 10-year annualised return of 7.24%, versus 5.18% for the MSCI World Index. As expected given the inclusion of emerging markets, the volatility on the hypothetical portfolio has been higher, but only marginally so, and it actually suffered less of a drawdown during the financial crisis. (Keep in mind: in both cases the performance is based on index data, not investable products such as ETFs, so none of the costs of either investment is taken into account.)

The Pros of Taking a Piecemeal Approach
There are certainly some advantages to the piecemeal approach to building your portfolio. Foremost among these is that it gives you more control over how it looks. Want more emerging markets exposure? No problem. Don’t feel enamoured with parts of the eurozone? Feel free to underweight them. These could either be strategic moves reflecting the general way you think a properly balanced portfolio should look, or tactical based on your current view of what might outperform in the near term. Secondly, it allows you more scope to rebalance your portfolio at regular intervals or when market moves have brought it out of line with where you started. Market capitalisation weighted indices will give you increased exposure to the securities, regions, and sectors that have performed the best. The act of rebalancing things yourself, reducing what’s gone up in value and adding to what’s gone down, essentially creates a strategy of buying low and selling high, albeit by foregoing some of the positive effects of momentum. Finally, building your portfolio fund by fund allows you to diversify your exposure to a particular ETF provider, or a particular replication method, if you so desire.

The Cons of Taking a Piecemeal Approach
Perhaps the biggest drawback of the piecemeal approach is that it incurs additional trading costs. Each new fund you add, and each rebalancing, involves brokerage commissions, bid-ask spreads, and potentially market impact costs. Those costs can really add up over time, and need to be weighed against the benefits of increased granularity. Beyond explicit costs, the more hands-on approach requires increased time and effort, both to choose the funds to buy, and to monitor and rebalance them. Moreover, there are more moving parts to keep track of. Your stable of funds might be denominated in different currencies, or employ different ways of distributing dividend income. Faced with all this, some investors may reasonably decide to buy the broadest fund they can, and call it a day. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.