John Spence

International Week - Q&A with Steven Schoenfeld of Barclays Global Investors

As part of International Week here at IndexFunds.com, we recently sat down with Steven Schoenfeld of Barclays Global Investors. He is the chief business strategist for BGI's international equity products, encompassing approximately $65 billion in developed international and emerging market index investments. This includes institutional portfolios and BGI's 34 international and global iShares exchange-traded funds.

Q: Some make the argument that when it comes to international investing, a sector-based approach is better than a regional- or country-based approach. The thinking is that it's a global economy, and country economies tend to move together. What are the advantages and disadvantages of the sector vs. regional approaches in international investing?

A: Country-level exposure has been the dominant consideration for investors when investing in international equities. However, as the importance of national borders decreases and capital market integration develops, this will cause global industrial classification to become a more dominant element of asset returns. Sector allocation strategies will become more appropriate and more valuable in global investing than country allocation strategies. While evidence that this integration has not yet materialized on a global basis, Europe - as a result of the European Monetary Union (EMU) - has begun the process of sectors surpassing countries in terms of asset allocation importance. The logical next step is likely to be from Eurozone or pan-European sectors to global sectors. Or at the very least we may see the combination of Europe, the U.S., and Japan into a highly correlated sector framework. In response to the growing significance of the industry effect, investors are becoming increasingly interested in sector and size indexes for this asset class. These sub-indexes give the investor the ability to analyze and monitor specific sectors whether in active management or as the basis for an index fund. When looking at sector overweights or underweights, it makes more sense to do so on a global basis, rather than just a U.S. or international basis.

"Return enhancement" is not the reason to invest internationally - it's icing on the cake, and it happens in unique moments in time. The fundamental strategic reasons are completion of exposure, expansion of opportunity set, and risk reduction.  -Steven Schoenfeld, Barclays Global Investors

Q: Should investors view international diversification as a "returns-enhancing" or "risk reduction" strategy, or something else?

A: Primarily, international diversification should be thought of in terms of "completion of exposure" or "expansion of the opportunity set." Secondarily, diversification, risk reduction, and return enhancement can be considered icing on the cake when it occurs.

So much attention regarding international stocks in a portfolio has been focused on the efficient frontier, on how to reduce risk and enhance return. In the late 1990s international diversification didn't appear to do that, so some said it hasn't delivered on its promise. But international has reduced risk because you are reducing the standard deviation [a measure of volatility] of your portfolio by adding relevant amounts, say 20% of your portfolio, of international equities. This unambiguously reduces the standard deviation of a portfolio that would otherwise contain all domestic equities. It's the same argument for adding bonds to a portfolio. Diversification and risk reduction are the secondary points.

However, the primary point that hasn't been spoken about enough in my opinion is simply the completion. Investors have a strong bias toward their home market, and they're getting an incomplete exposure to the world's opportunity set. U.S. investors think they're getting away with this because we have big multinationals, but these companies tend to correlate with the domestic economy. They also say the U.S. represents a large percentage of the world market, and of course you had the "we rule" arrogance of the go-go 1990s.

Many companies and products we consider American household names are not in your U.S. equity portfolio. Seven foreign companies were recently removed from the S&P 500, which only strengthens the need for international diversification.

The fact remains that the U.S. is only about half of the world's market capitalization, and you're missing out on very important companies if you exclude international. There are moments of opportunity when you want to capture the changes in world demographics and economies.

I want to stress that "return enhancement" is not the reason to invest internationally - it's icing on the cake, and it happens in unique moments in time. The fundamental strategic reasons are completion of exposure, expansion of opportunity set, and risk reduction.

Q: One of the biggest stories in indexing last year was the rebalancing of the MSCI international indexes for free-float. Are investors benefiting from the switch moving forward and how?

A: One immediate benefit is a broader, deeper, and therefore better benchmark.
This helps index-based investors unambiguously with better representation of the asset class, and end-investors regardless of the strategy they're in. Better benchmarks are harder to beat, and better represent the asset class.

Several other benefits are becoming visible, but can't yet be fully confirmed. These include lower turnover, more harmonization of returns between major benchmarks, and better relative performance of indexes - and index funds - relative to traditional active managers.

Q: Barclays Global Investors is one of the largest global managers of indexed investments. What type of relationship do you have with the index providers, and are there situations where you are proactive with them, and vice versa?

A: We have a close relationship with the global index providers, and we dedicate substantial resources to maintain a dialogue with them. We've hired alumni from the major index vendors who understand the methodologies. We think this helps our clients because we understand the indexes, but it also helps the industry because we're helping make the indexes better benchmarks. That's good for all index investors, and we think for all asset owners. The only people it's bad for are underperforming active managers who have a tougher benchmark to beat, but I don't lose a lot of sleep about that.

The growth of exchange-traded funds has deepened the areas for partnership with the index providers. We don't view our relationship with index providers as an adversarial one, but as an opportunity for partnership.

Q: BGI filed to introduce an emerging markets ETF. Here's some of the common traditional criticisms of investing in emerging markets: shaky corporate governance, transparency, and disclosure. Obviously, those criticisms could now be directed at U.S. companies given today's newspaper headlines. The notion that the U.S. is untouchable in technology and regulation isn't airtight anymore. Will this reversal affect attitudes regarding investing in emerging markets?

A: Emerging markets valuations long have suffered from the perception of poor corporate governance and disclosure. The news is in the price. Yet emerging markets have actually undergone much transformation in this area, especially since the Asian and emerging market crises of 1997 and 1998. The U.S., however, has not until recently seen these issues reflected in equity valuations. As a result, the relative corporate governance or disclosure risk is mispriced in favor of emerging markets, suggesting that there is much more upside than downside risk. The emerging markets performance - twice the S&P this year and 3% annualized 3-year outperformance - provides some evidence that investors are beginning to recognize this.

Q: Regarding international ETFs, what is Barclays working on? Which asset classes represent the greatest potential demand from investors?

A: In the short term, we'll be introducing an emerging markets ETF, and also down the road we're looking into an ETF tracking the S&P ADR index. We see enormous interest in international style indexes, and we're committed to introducing international value and growth ETFs as soon as practicable.