The value of global shares in a downturn

The unquestionable benefits of franking credits from Australian shares, and a history of generally strong Australian share investment returns, means that Australian shares tend to dominate the investment portfolios of Australian investors – a significant ‘home country’ investment bias.

That bias is not without foundation – the Australian sharemarket has been one of the better performing in the world.

Indeed, this year’s Credit Suisse Global Investment Returns Yearbook shows that over the very long run period (1900 – 2019), Australian shares provided the highest investment returns of any of the 21 country sharemarkets in their sample.

Add to that the additional return for local investors from franking credits, adding an extra 1 per cent per year or so in after-tax performance, and Australian shares have been an attractive investment class for Australian investors.

It is no wonder that they are a significant asset class within portfolios.

However, as the warning on any financial product goes, past returns are no guarantee of future returns.

The ATO’s September 2020 statistical report on self-managed super funds shows that of the $700 billion of members' assets, less than $9 billion are invested in overseas shares or overseas managed investments.

Another $168 billion is invested in listed/unlisted managed investments, which may include some international shares and increases this $9 billion, however, the take away message is fairly simple – there is not a great deal of international share exposure in Australian portfolios in most self-managed super funds.

Home bias is significant. And, as much as the financial services warning reminds us that past returns are no guarantee, many investors seem to be pretty happy with the assumption that Australian shares will continue to provide attractive future returns.

The focus of this article, which considers the value of international shares in a portfolio, are the periods of the Global Financial Crisis (GFC) and the current COVID-19 downturn. These recent challenging investment times are considered, to see whether investor portfolios would have been better served by having international exposure.

The performance of global shares in the GFC and COVID downturns

It is always interesting to talk about diversification in a theoretical context, however, the most important time to be seeing the benefits of diversification are during challenging market conditions.

2008, the heart of the GFC, was one of the worse calendar year returns for Australian shares, down 40.4 per cent for the year.

In contrast, that year was a relatively strong year for global shares, up 13.4 per cent, largely on the basis of returns from owning overseas assets with a falling Australian dollar.

Global shares (currency hedged) saw a return of -24.9 per cent for the year, still significantly better than the return from local market shares.

The market return figures for the 12 months to the end of November 2020, effectively capturing the COVID-19 market downturn and recovery, also provided support for the role of global shares in portfolios during this year’s downturn.

Over this period, the Australian shares index provided a total return (capital growth and dividends) of -1.4 per cent. Over the same period, the unhedged international share index provided a total return of 5.59 per cent, while the hedged international index a return of 9.64 per cent and an emerging markets index investment a return of 8.65 per cent.

The reality is that in both the GFC and COVID downturns, portfolio losses were reduced in portfolios with exposure to global shares.

To hedge or not to hedge?

A key question in thinking about global investments is whether or not to use currency hedging.

Unhedged global investments tend to be slightly cheaper, and more tax effective. There are also arguments that they provide a greater diversification benefit.

I also think of unhedged global investments as being somewhat of a ‘banana republic insurance’ – if for some reason things got particularly messy in Australia, owning overseas assets in overseas currencies will provide for greater purchasing power.

That said, there is no reason to have to choose one strategy over another, and including some hedged and some unhedged global investments provides two sources of portfolio diversification.

Conclusion

‘Past returns are no guarantee of future returns’.

Given the long history of the Australian sharemarket as a world leading source of returns, and the fact that, as Australians, we can capture the benefits of franking credits, it is not surprising that there is a significant home bias in Australian investment portfolios.

The questions are – to what extent should we challenge the central role that Australian shares play in our portfolios? Is it really a problem if the Australian sharemarket, worth just over 2.1 per cent of the world’s sharemarket, makes up 40 per cent, 50 per cent or 60 per cent of portfolios?

If the investing ideal is to be well-positioned whatever happens, then these questions, and a few others, are worth thinking about when considering asset allocation.

What if the long period of time during which the Australian market has led the world in returns is followed by an extended period of underperformance? What if there are important global companies, and market sectors, that are better accessed by investing overseas? And, as supported by the returns from global shares during the GFC and COVID-19 downturns, what if having exposure to global shares helps support portfolios during market downturns?