This In Practice piece gives a practitioner’s perspective on the article “Global Equity Fund Performance: An Attribution Approach,” by David R. Gallagher, Graham Harman, Camille H. Schmidt, and Geoffrey J. Warren, published in the First Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Amid widespread analysis of the performance of US equity funds, only a handful of studies have considered the performance of global equity funds. This is surprising given the growing allocation to global equities, even among US investors who have traditionally invested predominantly in domestic equities.
In light of the after-fee underperformance sustained by active US equity fund investors in aggregate, the authors were curious to see whether active global equity funds could outperform their benchmark. If so, they asked, what is the source of this outperformance? Is it stock selection, allocation to the best-performing markets, or perhaps currency management?
How Do the Authors Tackle This Issue?
Using a dataset of quarterly holdings of 143 global equity funds over a 10-year period (2002–2012), the authors not only calculated excess returns but also performed an attribution analysis to identify the chief sources of any outperformance. They also analysed to what extent any excess returns relative to the benchmark were due to stock selection, country selection, and currency.
The authors’ decision to include an analysis of currency takes the attribution analysis further still and is designed to identify whether the contribution from country selection is due to market allocation or currency selection. An increased understanding of how much currency contributes to global equity portfolios could, the study argues, help portfolio managers better manage their currency exposures.
What Are the Findings?
The authors found that, on average, global equity funds outperform their benchmark by 1.2% to 1.4% a year before fees. Institutional investors still enjoy significant returns after fees. But for retail investors, excess returns are largely consumed by fees.
The finding that, in aggregate, global equity funds outperform their benchmark may surprise investment practitioners, given the aggregate underperformance of active US equity funds. The authors identify two principal sources for this global equity fund outperformance.
The first is stock selection. The attribution analysis revealed that the primary source of excess return is the selection of stocks that beat their local markets. The authors found that the contribution from stock selection is strongest in Japan, but it is also evident, although to a lesser extent, in most regions.
The second source of global equity fund outperformance is allocation to emerging markets. Overall, country selection does not contribute to excess returns, with the average quarterly contribution from country selection an insignificant 0.08%. However, substantial excess returns are available from allocating to emerging markets, especially those in Asia Pacific and Europe, the Middle East, and Africa (EMEA).
By contrast, global equity fund managers are found to possess little skill in currency selection or else to ignore the effect of currency altogether, thereby leaving their portfolios exposed to the risk of losses related to currency movements.
What Are the Implications for Investors and Investment Professionals?
The findings confirm that active management is worth considering in global equity investing, given that the average global equity fund demonstrates stock selection skill, emerging market capabilities, or both.
There are a number of practical implications from this study. First, the outperformance of global equity funds suggests that institutional investors that can access segregated accounts, which have lower fees, should consider active management for their global equity allocations.
Second, given that the primary sources of excess returns to global equity funds are stock selection and emerging markets, investors might consider choosing managers who adopt a bottom-up approach that emphasizes stock selection and managers who have emerging market capabilities. Equally, investors might be more sceptical about top-down managers who focus on country selection.
Third, the lack of skill in generating excess returns from currency management bolsters the case for separating the management of currency exposures from the management of equity portfolios, perhaps via currency hedging or currency overlays. However, given the evidence about currency mean reversion, this implication may be less relevant for longer-term investors.
Finally, it should be noted that this study does not consider the entire global equity universe and does not employ any specific selection process. So, institutional investors who can select managers who have certain characteristics associated with future outperformance may be able to achieve even higher returns.