Asset Allocation and Portfolio Diversification

The primary tenet of portfolio and risk management is that diversification among asset classes both increases long-term returns and decreases long-term risk. Although there's any number of exotic ways to achieve diversification, one of the easiest and cheapest methods within a pure equity framework has historically been international investing. This process combines the general risk/return profile of domestic equity investing with the added diversification of investing in different economic climates.

The correlation of the U.S. and world markets--the primary diversification benefit--has risen and fallen over time. During certain periods, when all the major economies are simultaneously expanding or contracting, the correlation between the markets is greater, and the diversification benefit is smaller. Over longer periods of time, however, the major economies move independently and provide significant diversification.

The most widely used benchmark for the international developed markets is Morgan Stanley Capital International's Europe, Australasia, Far East (MSCI EAFE) Index. This is tilted toward the largest companies worldwide, as well as toward Europe. (To wit, 16 of the 21 component indices are European countries.)

These flaws notwithstanding, the EAFE Index represents the national indices of most of the major countries across the globe. Beyond exploring the differences in the nations and their economies, international investing also opens up a wider array of investment candidates--companies with excellent products and valuations that wouldn't be available to the strictly domestic investment manager.

Most separately managed account managers invest in American Depositary Receipts (ADRs), which are pooled versions of the equity shares of each foreign company that trades on the New York Stock Exchange. This process simplifies the trading and settlement of the securities, making it cost-effective to trade in these shares.

Unfortunately, this also leads to a significant portfolio bias for most SMA managers toward the largest foreign corporations whose ADRs are widely available on the NYSE. Mutual funds often trade directly in the ordinary shares of foreign companies across their respective local stock exchanges, as their size and back-office operations make it cost-effective to open up additional investment opportunities in these markets.

Spotlight Manager: Metropolitan West Capital Management

One offering that takes advantage of these aspects of international investing is Metropolitan West Capital Management's International Core Value product. As it is in any other segment of the market, there are a number of different approaches to international investing. Studies have shown that the majority of a security's return is due to company-specific factors, rather than economic sector or country of origin. This is why MetWest focuses its research efforts on individual companies, instead of attempting to forecast which regions or sectors will be the best performers during the next year.

MetWest's internal attribution analysis confirms this theory, as it derives more than 80% of its excess return over the EAFE benchmark through security selection. The firm's philosophy is that fundamentally sound companies trading at a discount to their intrinsic value have better long-term potential for investors. This encourages the research staff to identify quality companies that have significant cash flow, high reinvestment rates and a return on assets that's greater than the company's cost of capital.

Once a company with these characteristics has been identified, an intrinsic value analysis is applied. Although any valuation methodology can be largely subjective, MetWest's intrinsic value analysis allows for a comparison of the company's attractiveness relative to its competitors worldwide.

MetWest's portfolio is concentrated in the 35 to 40 securities in which it has the greatest convictions. Note that the average ADR portfolio in the relevant SMA universe typically consists of 50 to 60 names. These convictions lead MetWest to weight the portfolio in both economic sectors and individual countries.

Here's an example. The research team has found a significant number of companies that fit its relative value criteria in Japan during the last two years, and so the portfolio has been overweight in Japan by 3% to 4%, relative to the EAFE Index, for most of that time. The management team recognizes the portfolio's position relative to the EAFE Index and, as a matter of controlling risk, rarely overweights or underweights any of the major economic sectors or countries by more than 10%. Typically, 25% to 30% of the portfolio will be invested in companies with market caps ranging from $1 billion to $10 billion.

This is a key diversifier for the product, as the small- and mid-cap markets react differently from the large-cap ones. The management team has a relatively long investment horizon, with the holding period for each stock averaging nearly three years, which reduces portfolio turnover and makes the product more tax-efficient. Although this offering is relatively unknown in the retail world, its recent performance and an increase in assets under management should boost its visibility. (The portfolio has quietly topped the EAFE Index in each of the last three calendar years, as assets have grown to more than $150 million.) And while this is still a small asset base to be working from, MetWest has made a clear commitment to the product, and the firm overall has more than $3 billion in AUM.