How to do your own asset allocation to reap higher rewards

The world’s fastest-growing economies could produce significant returns for investors over the long run. Although there may be greater volatility and risk of loss from having exposure to countries such as China and India, doing so could lead to higher rewards for investors.

 Asset allocation

Although allocating assets using an alternative method may not be an exact science, having greater exposure to fastgrowing economies could provide investors with a tailwind in the long run.

The problem, though, is that many global benchmarks have low exposure to some of the world’s fastest-growing economies. This could lead to investors focusing their capital on economies that potentially do not represent the most favourable investment opportunities that are currently available.

Therefore, it could be a good idea for investors to consider an alternative methodology when determining the geographic allocation of their assets. Instead of using a global benchmark, they may wish to focus on countries that have the highest GDP, for example, or the largest population. They may even wish to zero-in on global megatrends such as urbanisation.

Although allocating assets using an alternative method may not be an exact science, having greater exposure to fast-growing economies could provide investors with a tailwind in the long run.

Global asset allocation

Investors who are seeking to gain exposure to a variety of economies across the world can access benchmarks such as the MSCI ACWI Index and FTSE All-World Index. These are relatively popular benchmarks used by fund managers and wealth managers to determine the proportion of a portfolio that should be invested in each of the world’s major economies.

Such benchmarks represent a variety of equities across a large number of economies. As with any type of asset allocation, deviating from the benchmark is commonplace among investors, with their views and opinions determining the extent to which they are underweight or overweight various economies.

One of the main limitations of global asset allocation benchmarks is that they have modest exposure to some of the fastest-growing economies in the world. For example, the MSCI ACWI Index has exposure of 3.6% to China, while the FTSE All-World Index’s exposure to India is only 1.3%. They are the second and sixth largest economies by GDP in the world, and are forecast to grow at annualised rates of 6.2% and 7.3% respectively in 2019.

Therefore, investors who focus on some global benchmarks may miss out to a large extent on the opportunities that are present in a number of the world’s most appealing economies. Although it is possible to gain additional exposure to companies that operate in China and India, but that are listed in countries which are more prominent in global benchmarks, this may be a more complex means of investing in the desired economies.

GDP asset allocation

Deciding where to invest a portfolio based on data other than that provided by a benchmark may provide greater exposure to faster growth opportunities. For example, allocating capital to countries based on their GDP would immediately provide greater exposure to India and China, while also maintaining a significant focus on other major economies that feature in global benchmarks, such as the US and Germany.

In fact, the largest 20 economies in the world by GDP account for over 80% of global GDP. Therefore, an investor would not necessarily need to consider a large number of economies, nor conduct an extensive amount of research, in order to gain exposure to the vast majority of the worlds economic output. Doing so would lead to a portfolio that has exposure of 24% to the US, while China would account for 15% of the portfolio and 3.3% would be invested in India.

The problem, though, with allocating geographic exposure  by GDP is that it does not take into account growth rates. For example, the US would be the largest contributor to the portfolio, but is not forecast to be the fastest-growing economy among the top 20 countries  by GDP.

Therefore, investors may still need to be willing to take an overweight or underweight stance on specific economies depending on their own level of risk aversion. But as a starting point, it could provide a more worthwhile exposure to the world’s leading economies.

Population asset allocation

Another potential means of deciding the proportion of capital to allocate to various countries is to focus on their populations. Doing so produces interesting results that arguably highlight the level of income inequality that exists in the world.

Countries such as the UK and France, which are the fifth and seventh largest economies in the world by GDP, are not among the top 20 most populous countries. In their place are a range of emerging markets, with countries such as Pakistan and Bangladesh featuring in the top 10.

Since, India, China and the US occupy the top three places by population, they would remain the main focus of any portfolio that is allocated by the size of a country’s population. Beyond that, the portfolio would be likely to focus on the emerging world, and could therefore offer higher volatility and greater returns in the long run.

As well as lacking a direct link with wealth, allocating assets within a portfolio by population size also fails to take account of forecast population changes.

According to the UN, the world’s population is expected to increase by 33% between now and 2050, with much of that growth being centred on Africa. As such, for investors who are seeking to gain exposure to economies that could experience rising demand for a variety of goods and services, it may still be necessary to make adjustments to weightings versus the benchmark.

Urbanisation asset allocation

There are a number of megatrends that are expected to impact significantly on the long-term global economic outlook, such as technology and climate change. Urbanisation is one such megatrend and could provide a useful basis on which to allocate a portfolio.

While 55% of the world’s population currently lives in cities, by 2050 this is expected to increase to 68%. Since over 80% of global GDP is generated in cities today, this figure is likely to increase over the long run. Therefore, it could be worth focusing on the growth potential of major cities, rather than solely looking at major economies, when deciding where to invest.

Urbanisation is forecast to be greatest across Africa and Asia with India, China and Nigeria expected to experience the largest impact from the megatrend. This could lead to investors having a relatively large exposure to emerging economies, which could increase their potential growth rates over the coming decades.

However, using the urbanisation megatrend to allocate assets may lead to increased risk, higher volatility and low exposure to established markets such as the UK.

Furthermore, some major urban centres could be impacted by other megatrends such as climate change as a result of their proximity to rivers and oceans.

A notable example is Nigeria’s most populous city, Lagos, which is built on the coast and incorporates a series of islands.

Asset allocation in practice

However geographic weightings are determined, the logistics of investing in a variety of countries are relatively straightforward.

There are local tracker funds, such as those offered by iShares, which aim to mimic the performance of stock market indexes in specific countries. With their costs generally being low, they offer an efficient and convenient means of gaining exposure to economies n which it may be more difficult for UK-based investors to purchase direct equities.

Of course, it is also possible to buy shares in a variety of companies that are listed across the globe. There are a wide range, for example, of Indian and Chinese companies that are traded as American Depositary Receipts (ADRs). This could make them more accessible to foreign investors.

With global benchmarks such as the MSCI ACWI Index and Ftse All-World Index offering frequent rebalancing, investors will need to ensure that their asset allocation is regularly reviewed. However, the regularity of data releases is likely to have the biggest impact on how frequently this process can be undertaken.

A global approach

While basing geographic weightings on data such as GDP, population and urbanisation trends may not provide a perfect solution to the asset allocation conundrum; neither do global benchmarks. The MSCI ACWI Index and FTSE All-World Index’s modest exposure to China and India, for example, could cause investors who stick to the benchmark’s weights in their own portfolios to experience lacklustre growth in the long run.

Although it is possible to use a benchmark that is focused on emerging markets as additional guidance for determining geographic exposure alongside a global benchmark, investors seeking a simple solution could feasibly decide upon their own asset allocation. Factors such as population growth and urbanisation are likely to have a significant impact on the world economy, while focusing on the world’s top 20 economies by GDP would mean that more than 80% of the world’s economic output is covered within a portfolio.

Therefore, using such data as a starting point and being able to adapt it to suit an investor’s own level of risk aversion and return goals could be a shrewd move. Given the growth prospects of many of the world’s emerging markets such as India and China, missing out on them through limited direct exposure could prove to be a source of significant disappointment in the long run.

Robert Stephens, CFA, is an equity analyst and runs his own research company.

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