New global funds have a go-anywhere approach, and they're gearing up to survive credit crunches and market corrections.
Want to keep your clients' asset allocation simple, yet generate a high portfolio risk-adjusted rate of return?
Advisors may have their doubts, but world funds, also known as global funds, may be the way to achieve those objectives. World fund managers are not stuck investing in developing or emerging markets far from home. They have flexibility to invest in any country or region in the world. In an increasingly global economy, markets may be more closely correlated than ever before, but the last five years of results are starting to show shifting funds from one market to another can enhance performance as much as moving from sector to sector.
Over one-, three- and five-year periods ended in August 2007, world funds outperformed a 50-50 split in the S&P 500 and MSCI EAFE by more than 100 basis points in annual return, according to Morningstar Inc., Chicago (see table 1). Meanwhile, the world funds, on average, sport beta values of 0.91 to the MSCI EAFE with an R2 (a measure of how closely the manager's returns match the returns of the market index against which it is compared) of just 79%.
Although global funds, on average, have registered stellar performance over the past few years, it might not be so easy going forward. Last summer, trouble in the credit markets created a worldwide liquidity crunch, leading to a crisis in confidence. Assets backed by subprime U.S. mortgages fell apart. As mortgage defaults continued to rise, the value of the collateral plunged.
The U.S. credit crisis quickly spilled over into Europe. In early August, central banks pumped $500 million into the credit system. In mid-September, the U.S. Federal Reserve cut its target for the federal funds rate to 4.75% and the discount rate to 5.25%. Both were cut by a half point.
However, by mid-September the London Interbank Offered Rate (Libor) was sharply above the Fed funds rate because of the credit crunch. Libor is a benchmark for everything from U.S. adjustable-rate mortgages to floating-rate bank loans procured by large multinational corporations. The rising Libor rate, analysts said, could hurt worldwide corporate profits as well as household finances.
Andrew Clare, professor of asset management at London's Cass Business School and a former economist with the Bank of England, warned that a slowdown in leveraged buyouts, initial public offerings and merger and acquisition activity would affect corporate earnings. He is concerned that even if the central banks of the world stave off a credit crisis, there still could be a longer-term impact on stock valuations.
Robert Gensler, manager of the T. Rowe Price Global Stock Fund, says investors should not expect the sizzling foreign stock returns of the past. "We believe the global economy will continue to expand, at a slightly slower pace than the rapid growth of recent years," he says. "But the global equity sell-offs serve as a reminder of the risk arising from a significant increase in investors' risk appetite. An unexpected pullback in the U.S. and global consumer demand remains a risk to the global economy."
The credit crunch, however, may not impact some sector earnings. Primarily, it would hurt financial stocks, says John Calamos, manager of the Calamos Global Equity Fund. Earnings growth in the information technology, health care and consumer sectors were strong and rising. "There is less synchronization in the global market than in the past due to globalization," he says.
Calamos' fund, launched in March, was up 16% as of August. He said that 2007 was a good year to launch his fund. Reason: He saw lots of opportunities. He invests in cash-rich companies with high and sustainable growth rates and below-average debt-to-equity ratios. These companies were growing earnings at more than 20% annually.
"We are positioned as a global growth fund," he says. "We want to take advantage of the shift occurring last year from value to growth. Globalization of the markets, because of the acceptance of free markets, has also resulted in less correlation to the U.S."
Calamos' 10 largest holdings make up about one-third of the $50 million portfolio. They include Apple, Nintendo, Google, Tandberg, Tremenos Group and Nobel Biocare Holding. And the fund had about 90% of its assets invested in Asia/Pacific, Europe and North America. The rest was in Latin America and the Caribbean.
Robert Taylor, co-manager of the Oakmark Global Fund, has used the global market corrections to add to current holdings. The fund has grown at a 21% annual rate over the past three years ending in August.
He's taken advantage of the market overreaction to credit problems by adding to existing positions such as UBS and Credit Suisse, which have little exposure to problems in the subprime lending market. Plus, they have cash-cow underwriting and money management businesses. Recently, these stocks had been trading at a discount of more than 30% to their liquidation value.
Taylor said the fund's largest holdings had the greatest upside potential. He also had a number of new stocks on his radar screen that he planned to buy if they continued to decline. On average, Taylor buys stocks that are trading at about a 30% discount to their intrinsic value. But he also wants to own companies with good balance sheets, strong cash flows and management that does a good job in allocating capital. Companies with high barriers to entry and strong free cash flow are ideal candidates.
"The benefit of our global fund is that it can invest worldwide in any size company," Taylor explains. "We are bottom-up investors that go where there is value."
Over the past couple of years, the fund benefited from private-equity leverage buyouts, as well as mergers and acquisitions. This, he says, is a secondary benefit of buying stocks on value.
Although private equity deals are drying up, Taylor expects corporate mergers and acquisitions will continue to boost the fund's return. Recently, Taylor sold his holdings in Ceridian, Brunswick and NTT Docomo because he spotted better deals in companies like Apache, a U.S. oil and gas exploration company; MDS, a Canadian life science firm; and Omron, a Japanese manufacturer of factory automation products.
The fund had about 44% of assets invested in U.S. stocks that were formerly considered large-cap growth stocks. Thirty-seven percent is invested in Europe. The rest is in the Pacific Rim, Canada and Latin America. Taylor is avoiding companies in the emerging markets because they are highly overvalued.
His biggest global market concerns are continued currency volatility and the potential for political and economic risks in Asia and Latin America. The fund's largest holdings include UBS, Rohm, GlaxoSmithKline, XTO Energy and Oracle.
Despite the fallout from the U.S. subprime market, Robert Gensler, manager of the T. Rowe Price Global Stock Fund, believes worldwide economic growth is strong. The fund was up 22% annually over the past three years ending in August.
He cites several statistics: The emerging markets' GDPs (gross domestic products) are growing 7% on average. The emerging markets contribute to about half of the world's GDP growth. In addition, Brazil's and Mexico's economies are growing at about 3% to 4%. Europe and U.S. GDPs are growing at a steady 3%. Plus, disposable income is increasing at a 2% rate worldwide.
The positive variables, he said, bode well for his holdings. He favors large-cap firms with competitive advantages that are operating in industries with stable to improving fundamentals. He wants to own firms with growing market share, sustainable profit margins, good free cash flow, ongoing product cycles and competitive valuations. The fund's holdings, on average, are growing earnings at about 25%.
In the long term, the outlook is bright. But in the shorter term, there are several risks, Gensler said. For example:
U.S. consumer spending makes up 70% of the economic growth domestically. So if the consumer gets tapped out, stocks could come under pressure.
European short-term rates are rising. Higher inflation is also a concern.
Valuations in emerging markets are no longer cheap. China and India are susceptible to sell-offs.
In Latin America, there are just a fistful of companies showing rapid profit growth.
"The key risk, be it global or regional, is to profits and margins," he says. "If they don't sustain these, you could have an issue." The fund has 43% in the United States, 37% in Europe, 20% in the emerging markets, 10% in Latin America and the rest in the Pacific.
Some of the fund's top holdings include American Tower Corp., America Movil, UBS and Goldman Sachs. He recently purchased CVRD, a Brazilian iron ore company, because of strong demand from China; Mitsubishi Estate, the largest Japanese real estate developer; and D.R. Horton, a single-family home builder.