At the end of August 2016, the weight of non-U.S. countries in the MSCI All Country World Index was 47%. Thus, investing in non-U.S. countries plays an important role in portfolios.
Global equity strategies are most often executed through actively managed funds that select stocks from multiple countries. One of the arguments for using actively managed funds in international markets is the perception by many investors that international equity markets are less efficient than the U.S. market, and, therefore, a potential source of abnormal returns.
David Gallagher, Graham Harman, Camille Schmidt and Geoff Warren, authors of the October 2016 paper “Global Equity Fund Performance Evaluation with Equity and Currency Style Factors,” contribute to the literature on the performance of actively managed funds. They used a holdings-based analysis to estimate the style factor exposures of 90 institutional global equity funds. This allowed them to isolate these funds’ sources of risk-adjusted returns.
The use of institutional funds is an important contribution. Specifically, as the authors noted, “institutional mandates can benefit from closer monitoring by informed investors/clients, and can be less exposed to any agency problems arising within fund families. Further, because institutional mandates are often managed as segregated accounts, they are not subject to the costs associated with providing immediate liquidity that arise within pooled, open-ended funds. These costs have been shown to reduce fund returns by around 1% p.a. or more.”
Their model included six well-documented equity factors: the market factor, value, size, momentum (MOM), investment-to-assets (I/A), return-on-equity (ROE) and illiquidity (ILLIQ). A key contribution of their study is the incorporation of currency factors into the model: trend, carry (reflecting strategies that aim to exploit the interest rate differential between countries, in which an investor borrows from, or shorts, countries with low interest rates and invests in, or goes long, countries with high interest rates) and purchasing power parity (PPP) deviation (a value-type factor).
Factor Analysis Results
Following is a summary of their findings, which cover the period 2002 through 2012: