This is the fourth in a series of five articles, written by John Morris and Nick Malaczynski, on international investment by pension funds. Morris and Malaczynski are the managing director and chief institutional consultant of TriStar International Consulting Limited, a company which provides international investment consulting services to South African retirement funds.
One of the main reasons for a pension fund to invest overseas is to diversify its portfolio, thereby reducing risk and improving performance.
When a pension fund invests a portion of its portfolio overseas, it is also important to diversify this portion.
Pension fund trustees need to consider how to allocate their overseas portfolio among different countries, assets, sectors, styles, and managers.
The risk of this diversification is that the pension fund's portfolio can be spread too thinly. It is important to impose a discipline on the diversification of a pension fund's overseas assets.
Here are five ways to ensure that portfolio diversification does not dilute your overseas portfolio performance:
* Country diversification. When investing overseas, avoid investing in every possible country. Instead, use appropriate quantitative analysis to determine which markets perform well while not correlating with the South African market.
A pension fund should invest in countries which historically have performed well when the South African market is performing poorly.
A pension fund will always have most of its assets in the South African market, and should focus its overseas assets in markets with a low correlation to the South African market.
* Asset diversification. Correlation analysis should play a role in asset selection. In addition, pension funds should invest in assets with appropriate risk-and-return parameters for the fund.
Speculative or highly volatile assets will probably not be appropriate for a pension fund.
Remember that when you mix assets you can and should achieve a solution which is better than the sum of its parts. It is this enhanced solution that you are adding to your domestic assets to reduce overall risk.
* Sector diversification. One of the reasons for a pension fund to invest overseas is to get exposure to market sectors which are not well represented in the South African market.
If it is your pension fund's strategy to invest in technology companies, you will probably want to consider companies like IBM, Microsoft and Intel in the United States, or a fund which invests in these companies.
One the other hand, it may not make much sense to invest overseas in a global mining fund which invests back into the South African mining industry. It is important to select sectors carefully when investing overseas.
* Style diversification. Investment style may be the least appreciated determinant of international investment performance. It is important to select overseas asset managers with complementary investment styles.
In South Africa, pension funds often select two or more managers with identical investment styles. The result is mediocre long-term performance and needless cost. The same result will occur overseas if pension funds do not allocate between different styles when selecting managers.
Select styles which complement one another by performing well under different market conditions.
* Manager diversification. The overseas asset managers whom pension fund trustees select should be determined by the investment strategy and allocation models they develop for their pension fund.
However, as a general rule, select a number of exceptional managers who each specialise in a particular sector, market, or region. No one international investment firm has all of the best portfolio managers.
It will always be necessary to select a number of complementary managers from different institutions to achieve the appropriate diversification for the portfolio.