The economic and geo-political seismic shifts over the past forty years imply a future that is drastically different from the past. In such an environment, the current market capitalisation, which reflects the historical reality, may not be relied on for building global equity mandates into the next decade. Institutions could benefit from building return expectations and global portfolios that consider these shifts, which would mean abandoning market capitalisation-based weights. Further down the road, a transition from regional allocation to a sounder economic exposure-based allocation would give the investment committees an even greater control over the risk and return profiles of their equity allocations.
Should we still do regional allocation of equities and if so, should we follow the same methodology as we have used over the last forty years? This question from one of our clients triggered this issue of Risk Wire.
Many institutions use regional equity allocation based on an approach dating back to the era of highly fragmented capital markets and home biases; an era in which companies had largely regional or even local revenue exposures and technological importance. As market access became
global, institutions were able to improve the risk-return profile by expanding the available investment universe and allocating globally, either using fixed ad-hoc weights, or later – transitioning to the market capitalisation-based weights.
In either approach, regional equity allocation, as currently performed, reflects legacy, historical realities. This is fine if the future is broadly similar to the past – a difficult assumption given:
- the changed composition of the world economy with the emerging markets (EM) being a much bigger part; the emergence of China as a dominant global power – one such example
- the unsustainable levels of inequality in major Western economies
- the transitioning of the economies to combat climate change
- consequences of 40 years of interest rate decline and the uncertain future rates
- aging in all the major economies changing the ratio between economically active and non-active population in a major way
- diverging implementation of legal frameworks
- diverging investment in human capital
- possible reversal of globalisation trajectory because of increasing trade tensions
- post Covid-19, bigger governments in all countries with larger debts
Webinar / Regional Allocation of Equities: The Next Decade
Full webinar is now available. Click below to access the recording.