For many reasons, the country weightings of mutual fund portfolios don't carry the importance they once did. But that doesn't mean that this information has lost all meaning. At times, it can help explain past performance, offer a preview of future returns under various conditions, and offer insights into the way portfolio managers approach their mission.
Fading Boundaries
As companies have put more and more effort into selling their products worldwide, with offices and factories scattered around the globe, the location of their headquarters has become less important. When investors are wondering whether to choose GlaxoSmithKline (GSK) over Novartis (NOVN) or Merck (MRK), the fact that their corporate offices are in the United Kingdom, Switzerland and the United States, respectively, typically plays little if any role in the decision.
That's logical, because the fortunes of globally oriented giants such as these depend on the economic and political conditions in a broad assortment of countries in which they do business, not just their home market. A few years ago, my colleague Michael Breen looked at the companies in the S&P 500 Index and MSCI EAFE Index one by one, and he found that a great many large U.S.-based firms derive half or more of their revenue abroad, while the fortunes of many ostensibly foreign companies rely to a substantial extent on the United States.
Similarly, a company need not be located in an emerging market in order to take advantage of emerging-markets growth rates. My colleague Kevin McDevitt explored that angle here. In fact, fund managers regularly explain that they bought a company in Europe or another developed market partly, or in some cases mainly, for its emerging-markets exposure. Anglo-Dutch household good producer Unilever (ULVR), Swiss chocolatier Nestle (NESN), and UK bank Standard Chartered (STAN) are often mentioned in this regard, but there are many others that fit that description.
This helps explain why many U.S.-focused stock funds tend to include at least a few foreign companies in their portfolios, and why most shareholders don't complain about that. The flexibility makes sense. Earlier this year, for example, the insurer Aon decided to move its global headquarters from Chicago to London. The news caused a stir in Chicago, but only a tiny number of jobs are slated to move and the rest of the firm's business likely will be unaffected (save for the lower overall tax rate that Aon cited as the reason for the move). For fund managers who own that stock, it would be odd if they decide that their "foreign" stake had suddenly risen just because a handful of Aon executives soon will be watching Arsenal instead of the Chicago Bulls.
It's Complicated
That said, it's not yet true that company location plays absolutely no role either in manager investment decisions or in fund performance. This was brought into focus in a recent conference call from the fund managers at Southeastern Asset Management, advisor to several Longleaf International funds.
For years, Longleaf International had a much higher percentage of assets in Japanese companies than most peers. No more--at least not for a while. The fund was stung in 2011 by the disclosure of a long-running fraud at Japanese camera- and medical-equipment-maker Olympus, but that isn't the only reason for the change. After all, fraud is hardly unknown in the United States and other countries. And the Longleaf managers didn't blame Japan for the fund's losses from that pick; they took responsibility for failing to accurately evaluate Olympus management. However, the response to the Olympus scandal, both from Japanese government authorities and from the company itself, fell far short of the minimum that a reasonable investor could expect in a developed market, in their view. Just as important, the managers said, Olympus is just one of a series of cases in Japan in recent years in which company management and official authorities had demonstrated serious shortcomings in governance.
No surprise, then, that Longleaf International's weighting in Japan at year-end 2011 was a mere 7%, down from 20% at the start of the year. The managers said that, from now on, they will require that any company they own in Japan have substantial management ownership--a trait they like to see in all their holdings but that they now will apply stringently in Japan.
As it turns out, it's not uncommon for managers to apply different standards when evaluating companies headquartered in different countries. James Moffett of Scout International has long avoided companies based in Russia or China because he has little confidence in either the companies' shareholder focus or the legal protections for investors in those countries. He's not the only one with those concerns. Other managers may not completely avoid these countries, or others where they have doubts, but tread much more carefully in such locations than they do elsewhere.
Similarly, during last summer's installment of the ongoing eurozone debt crisis, some equity-fund managers said they had taken advantage of indiscriminate selling in Europe to buy some global leaders at low prices, but others emphasised in interviews with Morningstar analysts that they owned little or nothing in Italy or Portugal or Spain or Ireland. Country of domicile certainly didn't seem irrelevant to these managers.
Effects on Performance
As everyone knows, stock market participants don't always base their decisions on rigid, logical calculations. Even if a company's stock price "should" trade at a certain level based on its fundamentals regardless of its location, that doesn't mean it will do so. When bad news about a country hits the headlines and stays there, many investors tend to reduce their holdings in that market without differentiating one stock from another. (Country-specific index ETFs make it easy to simply sell or trim the whole group rather than make individual decisions on companies.)
Similarly, emerging markets can trade up or down as a pack for brief or lengthy periods, even if the merits of individual companies in these regions vary greatly. In fact, the sweeping reversal of a broad emerging-markets downdraft, as much as anything else, helps explain why some international funds that had poor showings in 2011 rebounded strongly in early 2012.
What's more, the returns of funds that own foreign stocks feel the impact of currency fluctuations. When foreign currencies rise against the pound, the returns of such funds get a boost (if their currency exposure is unhedged). The inverse is also true. In fact, currency effects play a key role in explaining why foreign-focused stock funds lag or outperform their UK-focused counterparts by substantial margins in certain years.
Striking a Balance
It would make little sense for investors to try to micro-manage their overall exposure by individual country or region. In fact, given the classification issues and the fact that many funds' weightings can change from quarter to quarter, it's even hard to justify trying to maintain strict target allocations for overall foreign versus domestic exposure rather than merely having some broad ranges in mind. And it's worth remembering that geographic diversification can't work miracles; foreign stocks are unlikely to rise sharply during a year when domestic stocks fall, or vice versa.
Even so, the location of companies still carries weight. It's helpful for investors to know whether a fund has a relatively large stake in emerging markets or any particular region or has a strong tilt towards certain countries or currencies. That knowledge can help explain why a fund has performed a certain way in the past and provide hints of how it might perform under various scenarios in the future. At some point, such distinctions might not matter. But we're not there just yet.
