Changes to MSCI index make diversification more important

Andrew McAuley

Australian equity investors, including self-managed superannuation funds (SMSFs), have had a long term love affair with the local market, but they need to consider diversifying across other asset classes in the future or risk higher volatility and possibly lower returns than previously expected.

This is a theme that was given added impetus recently by the announcement by MSCI of the inclusion of onshore China A-shares in its return indices.

The MSCI indices are globally the most widely used regional benchmarks for stocks. These indices are of particular importance to passive index funds who match the weights of stocks in a particular index in order to produce a return equal to that index.

We expect that the change by MSCI will have a major impact on the MSCI Asia Pacific Ex Japan Index, increasing the weight allocated to China, and over time decreasing the weight of Australian stocks.

When this was announced a few weeks ago it was greeted as a significant change but one that would take a number of years to play out.

In the short term, it will probably have little impact as the weight allocated to onshore Chinese equities and away from Australian equities is small.

In the long term we believe that the proportion Australian stocks represent of regional equity markets will fall, and that it is inevitable investment funds will flow out of Australian equities into other regional markets, particularly China.

Under Credit Suisse’s current assumptions we expect China and Hong Kong will make up half of the Asia ex Japan equity benchmark by 2030, up from 20 per cent now, and that Australia’s weight in the region will likely fall by half from its current weight of 18.9 per cent.

If history is a guide it may take MSCI up to 10 years to enact this change, but it means over time there should be gradual and consistent selling by passive investors switching out of Australian equities into China shares.

This is important for the Australian market because almost 10 per cent of the S&P/ASX 200 top 20’s share registry is held by index tracking passive investors.

Regardless of what weight China settles at in the MSCI indices, its introduction is likely to increase the volatility associated with investing in equities globally. This is a result of an immature market, the large and uncertain impact a change in government policy can have in a command and control economy and the weight of retail investors who may be influenced more by momentum than fundamentals.

This change by MSCI is not in itself proof a multi-asset class portfolio is superior to a single asset class portfolio, such as Australian equities. But it is another example of events that can occur from time to time, and the risks inherent in a single asset class portfolio.

In our view, the best way to manage such risks is with a truly diversified portfolio incorporating local and international equities, bonds and alternatives. This is not to suggest we are prophesying doom and gloom for the local market.

Far from it.

Sooner rather than later

While the flow of superannuation money mandated for Australian markets will continue and there will always be opportunities for investors in the local market, investors running their own SMSF portfolios should at least consider diversifying into a balanced or other type of multi-asset class portfolio that reflects an acceptable level of risk to the investor. Once an investor makes that decision to reduce risk in their portfolio, it should be done sooner rather than later.

Consider the Credit Suisse Balanced mandate, which is a portfolio of bonds, Australian and international equities, hedge funds, and commodities. If we assume the asset class exposures were kept in line with the long-term strategic asset allocation (or neutral position) and index returns were achieved for each asset class, investors pursuing this strategy for the last 10 years will have enjoyed better returns than solely investing in the Australian stock market and with much less volatility.

However, one of the principal attractions for Australian investors into the domestic markets has always been the impact of franking credits on net returns. If we take the case of a SMSF taxed at 15 per cent, and back fill the impact of franking credits on the above scenario, this would have boosted the annualised return on the S&P/ASX 200-only portfolio to the point where the annual return is approximately 0.56 per cent above the balanced portfolio.

However, the Australian equities only portfolio achieves this return with a volatility more than 2.5 times higher than the balanced portfolio.

We would argue that the extra return associated with the extra franking credits is not worth the extra risk. But of course the final judge of this will be the investor.

Admittedly the time period in the above scenarios incorporates the market crash during the global financial crisis. However, even if we extend the analysis back to the beginning of 1998, a simple portfolio with 50 per cent in both long duration bonds and Australian equities, rebalanced annually, would have achieved a return slightly above the ASX200, and again with much lower volatility.

This occurs because a diversified portfolio protects the downside in equity sell-offs so the upside doesn’t have to be as large to recover the return lost.

Of course, this analysis is backward-looking and may not be repeated, but it does show the assumption that a standalone Australian equities portfolio will always outperform a portfolio that also includes bonds in the long run is incorrect.

We believe a portfolio diversified across various asset classes is the best risk adjusted way for investors to achieve their goals. The move by MSCI to include China A-shares in its indices is just one of many risks that will arise from time to time and will affect portfolios in different ways. What we can say for certain, is the most important decision an investor will make is what is the long term or strategic asset allocation for a portfolio. It is this choice that will dictate the returns and volatility a portfolio will produce in the long run.

Andrew McAuley is the chief investment officer, discretionary portfolio management, Credit Suisse Private Bank.

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