The value of this type of country analysis can be significant and have much greater impact on portfolio performance than security analysis.
Marshall L. Stocker, a CFA, global macro equity strategist and portfolio manager at Eaton Vance, says that empirical evidence shows “country selection explains at least half of an international equity fund’s excess return.” So investors, he says, should select fund managers “whose primary or sole endeavor is to identify the correct countries into which an international equity fund should be invested.”
Good Governance = Honesty and Transparency
The more honest and transparent a country is with its citizens, businesses and investors, the more wealth is created in the country.
Studies have shown that countries that have an open, honest and transparent economy outperform those that don’t. It is important to collect and organize country-level data about the proven ability of their economic infrastructures to deliver honesty and transparency.
As Martin Gilbert, chief executive of Aberdeen Asset Management, says, “The governance of countries affects the ability of companies to generate value within them, and it is in everyone’s interests to enhance the framework for business.”
Canada and Australia, as well as the countries of Northern Europe, are generally considered to have good governance, and our firm gives them high rankings. Some of the small equity markets also provide attractive opportunities. In 2008, Denmark significantly strengthened its already-good governance, particularly in the areas of shareholder rights and key aspects of financial services regulation. Since it made those improvements, the country’s equity market has enjoyed annualized returns of higher than 50% over the past five- and 10-year periods ending December 31, 2016. Given the relatively small Danish equity market, a portfolio using market cap allocations would have relatively small exposure to such an attractive opportunity.
Ireland is another country that has improved its governance, and its market has also enjoyed an annualized return of more than 50% over the past five years (ending December 31, 2016).
Behavior Is More Important Than Intent
Just because laws and regulations are in place does not mean they are enforced. A key factor in determining good governance is to assess what really happens as opposed to what is supposed to happen according to rules and public statements. Behavior is proof of good governance, but measuring it is not easy. When deciding on metrics, investors must have a way to determine the country’s adherence to good governance practices in an objective and repeatable manner.