Scouring the Globe for Alpha The logic behind global equity investing

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1 INSIGHTS Scouring the Globe for Alpha The logic behind global equity investing July 2009 Please visit for access to all of our Insights publications. Globalization continues to work its way through the world s financial system, as evidenced by changes in global securities markets, world trade and GDP trends, and international accounting standards. In recognition of globalization s powerful effects, investment strategies should take on a more global complexion. This paper attempts to address the following: Why is the demand for global equity strategies growing? How do the theoretical arguments for global equity play out in practice? Does an increased opportunity set necessarily equal higher alpha? Introduction Global equity investing, which blends U.S. and non-u.s. stocks within a single strategy, has emerged in recent years as an investment category with a growing audience among North American institutional investors. Advocates of the strategy point to the integration of global capital markets and the corresponding increase in new investment opportunities. Globalization continues to work its way through the world s financial system, as evidenced by changes to global securities markets, world trade patterns, economic growth trends and international accounting standards. As a result, sentiment is spreading among more and more institutional investors that investment strategies should take on a more global complexion in recognition of globalization s powerful effects. A second, but closely-related, argument in favor of global equity investing is that the enhanced freedom afforded to portfolio managers in a global mandate can offer investors increased potential for outperformance, an improved risk-reward dynamic and greater diversification compared to traditional domestic or foreign-only strategies. This paper articulates this rationale and gives a practical framework for comparisons between global equity mandates relative to their domestic and international counterparts on a risk and return basis. Recent data provide considerable support for global equity investing as a standalone mandate, underscoring the strategy s viability within an overall portfolio. Moreover, the notable inflow of assets into the strategy and the number of global mandates being added by institutional investors suggests an increasingly firm conviction in the strategy s distinct benefits.

2 Scouring the Globe for Alpha What does global mean? Determining the appropriate mix of domestic versus international market exposure is an important investment decision. Even when that split is resolved, an investor must additionally determine how to best divide international exposure amid various geographies within the non-u.s. space. In contrast, global equity investing sheds traditional geographical restrictions, allowing investment managers to pursue investment opportunities wherever they may be found. In addition to offering greater freedom in selecting individual securities, this potentially affords a portfolio manager freedom to make sector- and regional-based investment decisions that could add value to a portfolio. Therefore, investing in a global strategy offers access to opportunities in the U.S. and international markets, greater diversification across the globe and the investing insight and discipline of professional investment managers. World equity market capitalization Percentage of MSCI ACWI market cap U.S. 66% Rest of the World 34% Source: Factset, 1970; Factset, December 2008 U.S. 45% Global equity recent trends Rest of the World 55% Though global investing has been discussed in both academic and investing circles for a number of years, prior to 2005, investment in the global equity space was somewhat limited for both U.S. and Canadian investors. From 1998 to 2004, total global equity assets for U.S. tax-exempt clients hovered around $40 $60 billion (USD), and total initial funding for global equity mandates ranged from $1 $6 billion annually 1. Inflows into global strategies from Canadian investors were equally stagnant, but that inactivity was mainly due to foreign investment limitations imposed on pension plans. In early 2005, a regulation was lifted that required 70% of a pension plan s allocation be held in domestic assets. This freed plan sponsors to 1 Separately-managed account vehicle only Year-End Investment Industry Research Report of the U.S. Tax-Exempt Cross-Border Marketplace. (InterSec Research, 2008). expand their search for investment opportunities to the entire globe. Two years after the removal of the restriction, foreign investments grew from 24% to over 31% of total pension assets in Canadian employer-sponsored pension plans 2 Consequently, Canadian institutions have begun to adopt more global equity mandates. U.S. institutional investors also exhibited a predilection for domestic stocks and were slow to adopt global equity as a distinct investment strategy. The bias toward domestic investments is clearly reflected in defined benefit plan asset mixes at the end of 2008, corporate defined-benefit plan exposure to non-u.s. assets averaged about 14%. Taft-Hartley defined-benefit plans held even less, with approximately 10% in non-u.s. assets 3. In addition to impacting asset allocation preferences, U.S. institutional investors bias toward domestic securities resulted in a somewhat rigid perception of domestic and non-u.s. as two distinct strategies, a perception that has shaped allocation models for years and indirectly established resistance to global equity as a separate asset class. Yet the landscape appears to be shifting. U.S. tax-exempt global assets under management almost tripled from 2002 to 2007, surpassing a record $100 billion in In 2008, however, markets took a vicious turn. Originating as a credit crunch in the U.S. markets, the phenomenon quickly spread to the broader global markets, leading to solvency and capital inadequacy problems across markets and industries most notably in the financial sector. Commensurate with global capital market conditions, global equity assets under management declined back down to around 2004 levels. Interestingly enough, despite the challenging market environment, global equity investing seems to have held investors attention. Initial global active equity funding in 2008 continued to outpace both emerging markets and small-cap funding for the sixth consecutive year (Exhibit 1). In fact, if we compare the amount of new funding each asset class received during 2008 to its total assets at the start of the year (January 2008), global equity had the highest ratio versus emerging markets, regional, small cap and international 4. This shows that even in a year of muted investor activity, institutional investors demand 2 Statistics Canada. 24% and 31% refer to the percentage of total employer-sponsored trusteed pension fund assets invested in foreign instruments at the end of March 31, 2005 and March 31, 2007, respectively. As of September 30, 2008, the percentage declined to 29%, as global capital markets weakened. 3 Statistics are from the P&I 1,000, which are the top 1,000 largest retirement plans in the U.S. Pension & Investments, 4 New commingled and separate account fundings Year-End Investment Industry Research Report of the U.S. Tax-Exempt Cross-Border Marketplace. (InterSec Research, 2009). 2 Scouring the Globe for Alpha

3 Exhibit 1: Active Equity Initial Funding by Geographic Mandates ( ) Initial funding ($bn) International Global Emerging Regional Small Cap Source: InterSec Research, December 2008; U.S. Tax-exempt clients for new global equity mandates exceeded all other geographical mandates on a relative basis. On an absolute basis, aggregate institutional investments in global equity still amount to just a fraction of the assets invested in international equity, but an $11 billion initial funding number in 2008 represented a substantial gain, particularly in percentage terms. The increasing popularity of global equity investing has been led, to some degree, by demand from public pension funds. Many plan sponsors have increased their global allocation by trimming existing domestic and international mandates 1. For example, a U.S. plan sponsor might shift 3% out of U.S. equity and 2% out of international to create a 5% global equity allocation. At the same time, the number of global strategies available to North American investors continues to grow steadily, as evidenced by the number of managers reporting returns in both the Intersec and evestment Global Equity universes (Exhibit 2). Exhibit 2: Global Equity mangers reporting returns InterSec Global Equity Universe 39 evestment Global Equity Universe Source: InterSec Research, evestment, as of December The recent increase in the number of global equity managers reporting returns within the InterSec and evestment Global Equity universes is another indication that global equity, as an asset class, is expanding. Within both sample universes, the number of global equity data points has essentially doubled in the past decade, implying a growing recognition of the demand for global equities. This jump in products has come from two sources investment management firms have either created new products to meet the demand or they have transplanted existing global equity strategies that were originally targeted toward non-u.s. clients. The academic rhetoric, in a nutshell Globalization, the integration of economies, businesses and societies across the world, is often cited as the theoretical starting point for an examination of global investing. Modern economic globalization theory advocates a regulatory structure supportive of a free market economy and its tenets, including privatization and policies supporting competitive market forces. Especially in the last two decades, many economies have adopted these principles as a means to increase their productivity and investment potential. The following summary traces how economic globalization has transformed capital markets and ultimately, corporations: Government relaxation of capital flow restrictions has led to increased foreign investment into both financial market instruments (equity and debt) and real assets (land and buildings) A growing base of international capital market investors has encouraged the global accounting community to intensify standardization efforts to enhance transparency Financial integration, resulting from heightened financial and trade flow, in the past decade has resulted in statistically-significant co-movement between countries markets, conveying the increasing influence of non-domestic factors on market returns 5 Most importantly perhaps from a security analysis perspective is that in many instances a corporation s country of domicile has become a less important factor to its operations, including its prospects of revenue and profit generation In short, economic and financial integration requires an investor to step outside the boundaries of a region-specific analysis and utilize a broader perspective in understanding how global industry dynamics impact financial markets. It is our contention 5 IMF World Economic Outlook. As of April J.P. Morgan Asset Management 3

4 Scouring the Globe for Alpha that this is the key rationale for global equity investing; drivers of a given corporation s stock performance are no longer limited to country-specific factors, and in all likelihood, companies around the globe will continue to expand to foreign markets in search of cost efficiencies, growth and new sources of revenue. In a practical sense, when investing in a variety of companies, domicile (country of listing) is becoming less and less relevant as businesses operate on a global playing field. Putting the concepts into perspective As an investment strategy, the most important aspect of the global equity mandate is that it expands the scope of decisions/opportunities available to the investment manager. This places greater confidence in a portfolio manager s insights, unlocking greater potential for the manager to generate alpha on behalf of institutional investors. The data in Exhibit 3 highlights the theoretical expansion of available investments (assuming a benchmark-aware actively managed strategy), as we move from the U.S. (S&P 500) to non-u.s. developed markets (MSCI EAFE), and finally to global, with and without emerging markets (MSCI ACWI and MSCI World, respectively). Essentially, the broader the benchmark, the smaller the U.S. portion becomes. Measured by market capitalization, U.S. equities constituted 45% of the MSCI ACWI Index, the global benchmark that includes emerging markets, as of December of The second-largest constituent in the index is Japan, which amounts to 11% of the MSCI ACWI Index. The makeup of world equity markets has shifted significantly since 1970, when the U.S. totaled 66% of the index while the rest of the world accounted for 34%. On a GDP-weighted basis, the U.S. contributed just 23% to the world s total productivity at the close of 2008, based on the companies within the MSCI ACWI Index 6. Empirical patterns and current market activity suggest that this trend will likely continue over a longer term, reflecting both relative growth rates and the likely expansion of equity markets overseas. Global sectors expand investment opportunities Lifting geographical constraints on an investment mandate potentially gives the portfolio manager the ability to select the most attractive investment opportunities in the world, unencumbered by regional or sector restrictions. It is only logical that expanding the universe of securities from which to choose gives the portfolio manager greater opportunity to enhance investment returns on behalf of clients. Of course, the reverse could take place a global investment scheme could open the door for investment in underperforming securities. The energy sector provides a good test case of this concept. Widely touted as perhaps the most global of industries, we can see that not all opportunities within a sector are equally-attractive. U.S.-domiciled energy companies comprise approximately 49% of the world s publicly traded energy companies, and non-u.s. domiciled total 51%, a composition similar to the makeup of the global equity markets as a whole. Returns vary widely from Exhibit 4: Energy Sector Regional return dispersion (%) Region Weight 2008 return 10th 90th Dispersion of returns Emerging Markets Europe ex UK Japan North America Pacific Rim United Kingdom Source: FactSet. As of 12/31/2008 * Market-cap weighted. Data extracted from the MSCI All Country World Index ** The dispersion of returns is the range between the one year return of the 10th and 90th percentile. Exhibit 3: Benchmark decomposition Number of securities Market-cap weighted breakdown Emerging Emerging Index Countries U.S. EAFE* markets Total No. U.S. (%) EAFE (%)* markets (%) S&P MSCI EAFE MSCI World , , MSCI ACWI , , Source: FactSet. As of 12/31/2008 * Europe, Australasia, Far East (EAFE) developed markets. Also includes Canada in MSCI World and MSCI ACWI. 6 Morgan Stanley Capital Indices, December Scouring the Globe for Alpha

5 region to region within the energy sector (Exhibit 4), highlighting the expanded opportunity for value creation when taking a global investing approach. For instance, the top 10% performing energy stocks in 2008 from the U.S. and Canada returned -21% for the year. On the other hand, looking only at energy companies in the Pacific Rim, a top-decile performer would have delivered a 50% return. A portfolio manager employing a global investment strategy could have emphasized areas within the energy sector that are seen as possessing the greatest potential, such as Pacific Rim companies in This freedom of selectivity would not be possible in a more traditional domestic or pure non-u.s. mandate. A view of the energy sector at the company level points toward similar advantages for the global investor. Both U.K.-based British Petroleum (BP) and ExxonMobil (domiciled in the U.S.) are multinational energy companies. The companies possess similar geographic profiles, with only about 30% to 35% of their revenues generated domestically (Exhibit 5). In light of this, it may not be optimal to solely evaluate ExxonMobil alongside its U.S. peers, since the company is exposed to overseas risks and opportunities, global supply and demand forces, etc. (as is BP). A global mandate may allow a manager with sufficient insight an opportunity to choose the better company (BP versus ExxonMobil) regardless of where the firms are domiciled. The Alpha argument: Have global equity strategies delivered alpha from an expanded opportunity set? Because global equity consists of international and U.S. components, the strategy s absolute benchmark returns tend to largely fall in between U.S. returns and international returns. In addition, we tend to find the same distribution when looking at median manager returns (Exhibit 6). However, a comparison based on absolute returns may be a less relevant indicator than a relative return comparison, such as viewing performance versus an appropriate benchmark. At the end of 2008 a very challenging environment for all active equity mangers the median global equity manager outperformed the median international and U.S. manager on a 3- and 5-year basis, relative to their respective benchmarks the MSCI World, the MSCI EAFE and the S&P 500. Specifically, for the three-year period ended December 31, 2008, the median global equity manager generated 133bps of return in excess of the Exhibit 6: Absolute returns Median manager performance Global Equity EAFE U.S. Large Cap Core Exhibit 5: British Petroleum and ExxonMobil Domestic and international revenue source USD British Petroleum ExxonMobil year 3 years 5 years Percent Source: evestment. Absolute returns: Annualized and calculated geometrically Exhibit 7: 5-year excess returns Median manager performance 0 U.S. Source: FactSet. Fiscal year ending 12/31/2008 Energy International USD Global Equity EAFE U.S. Large Cap Core Source: evestment *Excess return is annualized and calculated arithmetically. J.P. Morgan Asset Management 5

6 Scouring the Globe for Alpha Exhibit 8a: Global versus International and U.S. managers Five year returns ending December 31, USD Global International U.S range of returns an investor will most likely receive from a mediocre to better-than-average global equity manager. The return dispersion (3.4%) for the global equity data is notably larger than both the international (2.4%) and U.S. (2.5%) ranges. The marginal increase in excess return for the median global equity manager is superior to the marginal increase for the median international or U.S. manager, illustrating the ability of top-performing global managers to add value. If an investor had chosen a top-quartile global equity manager, the global equity portfolio would have produced a minimum of 345 basis points of excess return, 132bps and 74bps above the top quartile international and U.S. manager, respectively. Exhibit 8b: Global versus International and U.S. managers Global International U.S. 25th Percentile Median th Percentile Benchmark* Dispersion Excess return 25th** Source: evestment. Returns are annualized in USD. Dispersion of returns is the difference between the 25th and 75th percentile. Universes: evestment Global Equity, evestment International Large-cap Core, evestment US Large-cap Core * MSCI World (NDR), MSCI EAFE, S&P 500 ** Excess return of 25th percentile-ranked manager over respective benchmark benchmark, while the median international and median U.S. manager generated 88bps and 101bps respectively. The five-year period saw a similar pattern, with the median global equity manager producing stronger excess return than the international and U.S. median mangers. Looking back five more calendar years tells an even more compelling story. The median global equity manager 3-year and 5-year excess returns have consistently outperformed their international and U.S. counterparts on a relative basis. Exhibit 7 highlights the 5-year periods. Exhibits 8a and 8b provide further details for the five-year period ended December 31, 2008 and showcases an interesting finding. Namely, the dispersion of returns for the entire global equity universe is much wider than for the U.S. and international universe, which is likely reflective of the greater possibility for uncorrelated strategies within an expanded global opportunity set. This is significant because the potential for excess returns notably strengthens as we move up the percentile ladder from the 75th to the 25th ranked global manager. The vertical distance between the 25th and 75th percentile-ranked manager represents the Furthermore, these higher returns are not concurrent with a marked increase of portfolio risk. On a risk-reward basis, the median global manager s three-year information ratio, which is the excess return per unit of risk/tracking error, is in line with international and U.S. mandates 7, despite the incrementally higher tracking error due to the dynamic nature of the strategy (Exhibit 9). The global equity strategy s risk-to-reward ratio measured over five years also supports this observation. Among higher-performing portfolios, if the investor had selected a top-quartile global manager, the portfolio would have achieved an IR of 0.8 versus 0.6 and 0.7 respectively for the top-quartile international and U.S. median manager. That implies the risk-adjusted excess return achieved by top-quartile global equity managers has been stronger over the longer-term versus similarly ranked international or U.S. equity managers. Hence, using these time frames, when compared to international and U.S. managers, global equity managers appear to deliver higher alpha while maintaining attractive information ratios over the longer-term. These statistics support the view that better-performing global equity managers successfully capitalized on their ability to move across regions and sectors to pursue enhanced returns. Exhibit 9: Risk and reward: Information Ratio Period ending December 31, 2008 Global Equity, EAFE and U.S. managers Global Equity EAFE U.S. 3 years Median years Median years 25th percentile Source: evestment Analytics Universes: evestment Global Equity, evestment International Large-cap Core and evestment US Large-cap Core 7 evestment Analytics, Based on calendar year returns of S&P500 versus MSCI EAFE. 9 The S&P 500 fell 37% versus the MSCI World (-41%) and MSCI EAFE (-43%). 6 Scouring the Globe for Alpha

7 A common critique: Do global managers only outperform when the U.S. underperforms? From 2002 to 2007, international equities outperformed U.S equities 8. During this period, global equity managers delivered substantial outperformance against both of those region-restrictive strategies. In calendar year 2008, however, the pattern reversed, with U.S. equities outperforming international equities 9. Isolating 2008, the median global equity manager underperformed the MSCI World by 148bps. The sudden shift to underperformance seems to point to the U.S. as the culprit. So that begs the question: Have global equity managers been outperforming their U.S. and international counterparts simply because of an underweight in the U.S. (which has had weaker performance)? When looking at regional weights in typical global portfolios, there does appear to have been a bias to underweight the U.S. in recent years. Exhibit 10 charts global equity managers weights relative to the MSCI World in tandem with the performance of U.S. equities (S&P 500) 10. From 2001 to 2008, global equity managers were generally underweight the U.S., as indicated by the blue bars. Whether this reflects a macro call or as more commonly cited a reflection of bottom-up stock selection, the question still remains: Have global managers outperformed simply due to a bias in underweighting U.S. equities? Exhibit 10: Global manager U.S. weights vs. relative performance of U.S. to international Rolling 3-year periods Source: 2008 Year-End Investment Industry Research Report of the U.S. Tax-Exempt Cross-Border Marketplace. (InterSec Research, 2009). Exhibit 11: Median Manager Excess Returns Periods ending December 31, 2000 USD Source: evestment, Global Equity EAFE U.S. Large Cap Core The data suggest the answer is not so simple. Tracing the median manager s U.S. active weights back to 2000, the trend changes, with global equity managers over-/under-weighting the U.S. seemingly unrelated to how the S&P 500 (U.S.) performed. In fact, looking at the year 2000 and the late 1990s, when international equities underperformed U.S. equities, the global median manager still outperformed the global benchmark. During the 3 year period ending December 2000, the median global equity manger outperformed both the U.S. and international median manager on a relative basis. During the 5 year period, the global equity manager also posted strong excess returns of 370bps, outperforming the median U.S. manager (Exhibit 11). In drawing conclusions, we need to be careful to look at data that extends beyond the turmoil that occurred in It is also worth pointing out that in 2008 as tumultuous as it was a number of global managers still outperformed. For the three and five year period ending December 31, 2008, approximately 63% and 75%, respectively, of managers added value above the MSCI World. The focus on which region tends to be the best performer ignores, to some degree, one of the strongest arguments for a global mandate, i.e. the ability of managers to identify the most attractive opportunity within a particular industry group on an unconstrained, or global, basis. In 2008, for example, disaggregating the MSCI ACWI benchmark according to the 10 MSCI sector scheme reveals that only in healthcare was a U.S. company the top performer (Exhibit 12) 11. Broadening the analysis to the top five performers in each of the 10 sectors, only 9 names of the top 50 outperformers in the index were based in the U.S. Conversely, 16 out of the 50 worst performers were U.S. domiciled. If we exclude emerging market stocks from the analysis, the result is no different. The U.S. represents 11 out of the 50 top performers and 23 out of the 50 bottom performers years 5 years Within the U.S. tax-exempt institutional investor space. 11 U.S. dollar total return. 12 MSCI World constituents, U.S. dollar total return. J.P. Morgan Asset Management 7

8 Scouring the Globe for Alpha Exhibit 12: MSCI ACWI Top performers by Sector Calendar year 2008 (%) Sector Domicile Return Sector Domicile Return Consumer Discretionary Industrials Japan Netherlands Japan Australia Japan Japan Mexico U.K U.S Japan Consumer Staples Information Technology Japan Canada Japan Taiwan Japan Japan Japan U.S China U.S Energy Financials Healthcare Materials Jordan Canada U.S Morocco Australia Taiwan Belgium Chile Norway Japan Telecom Services Japan Japan Brazil France U.S U.S Japan Morocco 6.16 U.S Taiwan 5.97 Utilities U.S Japan Japan Japan Japan Japan Japan Japan U.S Japan Source: MSCI ACWI (NDR) Index Conclusion Recent performance and market data provide a strong case for global equity investing as an emergent investment strategy. Against the backdrop of globalization, the traditional strategies are becoming decreasingly representative of actual business and investment trends, by which we mean that physical borders no longer bind or categorize corporations and economies. As developing countries continue to expand their output and increase efficiencies, the world stock markets composition and economic makeup will likely continue to shift away from the U.S. We believe active global investing offers potential for superior excess returns, provided that an investment manager has the global research capabilities and investing acumen to properly analyze a global marketplace. Global equity should be considered a strategy distinct from pure international or domestic investing, and thus, we recommend establishing a distinct allocation for a global equity mandate. Global equity s unique risk-return profile can serve as a valuable complement to an investor s asset mix. authors Nigel F. Emmett Managing Director Global Equities nigel.f.emmett@jpmorgan.com Stephanie Ng Associate Global Equities stephanie.m.ng@jpmorgan.com This commentary is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. The information is not intended to provide and should not be relied on for accounting, legal, or tax advice. Past performance is no guarantee of future results. Please note that investments in foreign markets are subject to special currency, political, and economic risks. The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met. J.P. Morgan Asset Management does not make any express or implied representation or warranty as to the accuracy or completeness of the information contained herein, and expressly disclaims any and all liability that may be based upon or relate to such information, or any errors therein or omissions there from. This material must not be relied upon by you in making a decision as to whether to invest in the opportunities described herein. Prospective investors should conduct their own investigation and analysis (including, without limitation, their consideration and review of the analyses referred to herein) and make an assessment of the opportunity independently and without reliance on this material or J.P. Morgan Asset Management. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. In addition investments in emerging markets could lead to more volatility in the value of an investment. The small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management Inc. 245 Park Avenue, New York, NY JPMorgan Chase & Co. IM9608