US President Dwight Eisenhower famously mentioned the ‘falling dominoes’ principle in a press conference in 1954, suggesting that after the fall of Vietnam to communism, South Asia will follow suit.
The domino theory, ripple effect and butterfly theories essentially deal with the concept of chain reactions to small events, which may have a widespread impact. While these concepts emerge from diverse fields, they seem suited to the financial world which is beset with uncertainty.
But the extent to which the domino effect impacts the globally connected economies differs with each region.
This is due to the diversity in political, geographical and economic situations in each economy. In such an uncertain investment milieu, diversification helps to strengthen the investment portfolios from a risk perspective.
Internationally, investors are spoilt for choice with a multitude of asset classes that cater to every risk profile. Globally-savvy investors may today swear by the leveraged bank bonds that exploit the deposit rate differential between countries using high leverage, or real estate derivatives in the alternative space.
More exotic variants in the form of newly-introduced credit swap ETFs may find favour with highly investment-savvy individuals. But most of these options may not be available in India.
‘Performing’ assetsSo, does it make sense to simply identify a high-yielding asset class and blindly invest in it? Let us take real estate for example. At a micro level, Argentina’s housing market has done stupendously well, returning 30 per cent in 2013.
But the same market was stagnated between 2010 and 2012 even as other emerging markets like India did well during this period, yielding 30-35 per cent. But from 2012 onwards, these markets have slowed down.
It would be a classic case of investors chasing well-performing markets and ending up losing, if someone had invested in Argentina between 2010 and 2012 and then shifted money to Asian markets after seeing the performance.
Often, combining asset classes in a scientific way may lead to a dramatic fall in portfolio risk profile. Correlation is the way in which different asset class returns move in relation to each other. The trick is to identify and combine asset classes that display low correlation.
An exercise was run to find out the impact of global diversification on a domestic portfolio, comprising mainly Indian equities and bonds. To this portfolio we added a developed market stock index and an international gold and composite commodity index.
These three international asset classes were chosen on the basis of low to negative correlation with Indian asset classes over a 10-year rolling period. This portfolio with global diversification beat the domestic two-asset portfolio on risk-adjusted returns, scoring at least 62 bps higher per annum. Over a longer term, this differential would compound into a sizeable number.
Exposure to global investment products gives one access to geographical markets with high growth. Currency diversification is another benefit accruing from global investment.
Investors may tap into different options such as equity, exchange-traded funds, fund of funds or multi-asset offshore arbitrage funds, through an Investment Advisory Account.
Investments can also be undertaken directly in other countries by way of real estate, buying offshore mutual funds and also through global market-linked insurance products that offer high sum-assured with global mutual funds as the underlying asset for the product. These investments are suited for aggressive risk profiles.
Odds of global investingInvestors should however take note that with domestic market growing at a phenomenal rate, there could be some opportunity cost associated with global investing.
A strengthening rupee also has the potential to diminish the gains accrued through global investment.
The writer is CEO & MD, ASK Wealth Advisors. The views are personal