Taking an international approach to managing risk

Taking an international approach to managing risk

It is common for investors across the world to show a home bias.

That is, they tend to focus their investments in their domestic rather than global markets. In this country some defined contribution default funds may have as much as 50 per cent of their equity allocation invested in UK stocks.

We think this exposes members to substantial and unnecessary risk and may ultimately leave them with disappointing outcomes. 

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Putting large proportions of a scheme’s equity allocation in the FTSE All Share, for example, isn’t simply an investment in the familiar and visible. It places big bets on certain sectors.

The UK market is dominated by a number of key sectors such as banks,oil, gas and mining companies. It also creates a relationship between a worker’s future earnings - which are often at least partially dependent on the stability and success of the domestic economy – and the returns on their pension savings.

Well-managed global equity funds are a cost effective way to gain broad exposure to the world’s major markets. 

There may be good reasons to stay close to home for a portion of a scheme’s investments, for example to balance out the effects of domestic inflation that could otherwise erode the value of members’ money over time.

At NEST we use inflation-linked gilts and UK direct commercial real estate investments to do this.

But diversifying beyond domestic borders creates more opportunities as well as avoiding home-bias risks.

For example, there are opportunities for growth in the technology sectors of the US, Korea and Japan or the industrial and manufacturing sectors in the fast growing emerging economies.

Interest rate and currency fluctuations across the globe also create opportunities.

Sophisticated international investors should therefore be able to get better long-term risk adjusted returns than those with a narrower regional focus. 

However, global investing is not without its challenges – the more markets you are exposed to, the more unique conditions you have to understand.

In emerging markets, for example, market capitalisation is often a less useful metric for determining a company’s underlying value than in more developed markets. NEST gains some of its emerging market equity exposure from a smart beta fund which aims to correct for precisely this issue.

Another issue is that some countries have better standards of corporate governance than others – this means the global investor has to be wary of the environmental, social and governance (ESG) risks they are taking on.

NEST’s selection of an ESG-screened emerging market equity fund and an active emerging market debt fund helps us keep tight control on these risks.

The various ways of accessing global growth available to schemes today means members shouldn’t be exposed to the risks associated with home bias unless there’s a good reason.