Offshore diversification: factors to consider before taking the plunge

Economy January 21, 2014 00:00

By Vira-anong C Phutrakul

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As the Year of the Horse approaches, both local and international events have started many of our hearts galloping. Locally, it will be a challenge to see how we can emerge from the political impasse that is affecting our economy and, surely, the investme

Globally, 2014 is actually shaping up to be an exciting year as the world economy transitions into growth. The transition for global investors actually started last year with a shift from fixed income to equities, with balanced funds as the main source.  
Equity markets rewarded investors well, with MSCI World up 20.25 per cent, S&P 29.6 per cent, Europe 20.15 per cent and Japan up 51 per cent in 2013. The strong performance in equities primarily came from economic recoveries in developed markets and North Asia.  
That said, the US Federal Reserve’s tapering announcement in the middle of the year resulted in rising yields, affecting fixed income and with startled reactions spiralling down the bourses in many Asian markets, including Thailand. These have now more or less normalised.
The outlook for 2014 from most economists points to a bull market that will be supportive for equities based on improving gross domestic product in developed markets, ample liquidity, low interest rates, strong US corporate fundamentals, a pick-up in global manufacturing, and a stabilising Europe. 
With the local investment environment being unpredictable with more downside at the moment, there is a strong rationale to diversify the portfolio with offshore products, especially to markets that are expected to outperform the home market.  
But before you take the plunge, there are key points to consider.
The first is how to manage foreign-currency exposure. Global investment involves securities from a variety of different countries that are denominated in different currencies. Consequently, foreign investments are subject to fluctuations in both the prices of individual securities in their local currencies and the value of these currencies versus baht. 
There are two extremes – unhedged portfolios and fully hedged portfolios. Being unhedged simply means that its holdings are denominated in local currencies and subject to currency fluctuations relative to the baht. A fully hedged one, on the other hand, involves using forward currency contracts to neutralise currency fluctuations, thereby leaving investors with a “pure play” profile. 
Between these two extremes, there is a continuum across which investors may hedge as much or as little of the currency risk as they choose. Unhedged global portfolios offer investors diversification away from the baht, but they also tend to be considerably more volatile because of currency fluctuations. 
The degree of currency hedging depends on an investor’s risk tolerance. For investors who are not comfortable with currency volatility, a fully hedged global portfolio is recommended, which will reduce the risk level of a portfolio but sacrificing some return. 
The second point is on the composition, size, and scope of the global securities. This is especially critical for fixed income as the universe of it has dramatically changed over the past two decades. In the past, government bonds dominated the fixed-income landscape; since then, a more diverse global fixed-income market has evolved into credit-related securities such as corporate bonds and securitised bonds backed by commercial and consumer loans such as those for homes or autos, credit cards, and so forth.
Like all investments, diversification is key. Adding a global component to a domestic portfolio provides a greater opportunity for diversification. Moreover, diversifying across currencies, sectors, and issuers in the global market also helps reduce the overall risk of the portfolio. 
Nowadays, investing in offshore products does not necessarily mean having accounts offshore, though many investors may already have or will establish accounts for business and/or personal needs. Locally, there are foreign funds that are wrapped by asset managers that originate from established funds in those markets.  Hence it is quite easy to diversify into offshore investment via mutual funds.
Given a bull prediction in global markets, perhaps it is time seriously to consider adding them to your portfolio. 
Whatever you decide, I wish you the best of luck in your investments and may the Year of the Horse bring us all great wealth and prosperity.
Vira-anong C Phutrakul is managing director and retail banking head at Citibank.