Research - "The Beta Theory" (pt. 1b) (focus: style category) Portfolio

Research - "The Beta Theory" (pt. 1b) (focus: style category)

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Created by mock portfolio

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Date updated:08-13-2007

- Title: "The Beta Theory - International 'Diversification' and the Global Financial System"
- The Focus: "Part 1b" looks specifically at the various "style categories" (large growth, large value, etc...). To see the performance of the global equity market over this period of time, see my portfolio entitled "The Beta Theory (pt. 1a)". To see other asset categories, go to "Part 1c"
- The time period over which this investing strategy could possibly work: the next 2-20 years
- Purpose of the portfolio I am tracking below: to give us an indication of what would be the "beta enrichner" that would allow us to lead in an up market, and what would be the "relatively safe asset". It could also hint to us when it is time to switch "beta enrichners". Finally, it could be an indication of risk appetites and global financial flows, among other things.
- Side Note: this pertains solely to inter-asset (equity only) risk-return relationships, and not across-asset relationships.

Part A: Increased global financial integration and sophistication + Increased interdependence of domestic and foreign output and asset growth (thus, increased global economic integration) (for the time being, at least; once this assumption changes, so does the end result) => Increased correlation between foreign and domestic equity markets...

Part B: Continued currency manipulation + continued willingness of foreigners (especially the Japanese) to pump excess savings into financial markets + continued willingness of oil-exporting nations to forego investing cash flows into domestic projects and instead pump these savings into financial markets => continued "global financial conundrum"

Part C: Continued financial innovation => greater ability for financial system to manage risk, greater risk appetite => greater risk taking (leveraging, etc...; this is also seen in hedge funds attempts to try and "arbitrage" divergance in domestic and foreign market returns) (side note: this obviously also leads to greater susceptibility of the financial market to very sharp downturns, specifically when investors bid up risky assets beyond the new "risk-return relationship" created through financial innovation).

Final Equation: "Part A" + "Part B" + "Part C" => Instead of looking at various companies as being your "individual securities", the various countries around the world are your "individual securities". Each of these different "security/countries" has a different beta (which is calculated relative to the "global equity market portfolio"). B/c of their high correlation, however, our international equity-only portfolio investment decisions (aka "international diversification") should not be based on the "diversification benefits of international investment", but rather solely on the beta of the various "country/securities", and our own prediction of where the market will go. The reason why "our international equity-only portfolio investment decisions should not be based on the diversification benefits of international investment" is because the benefits of international diversification are minimal, due to the increased correlation of the global economies and financial markets.
As mentioned above, as investors, this should mean that we focus solely on the direction of the global market (b/c the global market is what drives the global economy) - specifically on whether this means equity prices go up or down - and then load our portfolio's up on the "beta country" that best suits that play. Thus, if we believe that global economic strength leads to higher equity prices, we find the "beta maximizing country" and invest in it, and disregard the "beta minimizing countries". This, in turn, means reduced focus on individual companies and how they'd gain from "global expansion", and increased focus on just the general macroeconomic trend & figuring out the correct "beta country" to play that trend. ETF's would appear to be a good way to play this, as it would allow you to quickly exit in the case of a rapid change in global economic conditions, while giving you the complete exposure to the beta you want...

Side note #1: The situation above does not adjust for the fact that we may be unsure as to what is the general direction of the global economy. Such uncertainty would support spreading your wealth over different "levels" of "beta countries", and - more importantly - across asset classes. Again, the analysis given above only holds true for your equity-only portfolio. One NEEDS to be invested across asset classes for the future uncertainty that WE ALL face. No one knows for sure what will happen in the future. Thus, make sure to be properly diversified. The above theory is simply commenting on the increased emphasis that must be placed on what countries we're investing in rather than the company we're investing in, with the aggregate sum of our equity investments being dictated by the country rather than the company.

The implications (among many others):
I.- Your ability to generate absolute returns over the long-run is dependent upon your ability to determine: 1) the direction of the global economy; and 2) the "beta maximizing security/country" and the "beta minimizing security/country".
Specifically, your global economic forecast determines whether you should choose a "beta maximizing security/country" and the "beta minimizing security/country", which then dictate your absolute returns.

By: Matthew

(more coming soon...)

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