Question

John Irish, CFA, is an independent investment adviser who is assisting Alfred Darwin, the head of the Investment Committee of General Technology Corporation, to establish a new pension fund. Darwin asks Irish about international equities and whether the Investment Committee should consider them as an additional asset for the pension fund.

a. Explain the rationale for including international equities in General’s equity portfolio. Identify and describe three relevant considerations in formulating your answer.

b. List three possible arguments against international equity investment, and briefly discuss the significance of each.

c. To illustrate several aspects of the performance of international securities over time, Irish shows Darwin the accompanying graph of investment results experienced by a U.S. pension fund in the recent past. Compare the performance of the U.S.-dollar and non-U.S.-dollar equity and fixed-income asset categories, and explain the significance of the result of the account performance index relative to the results of the four individual asset class indexes.

Short answer

a. The opportunity for diversification

b. Not sufficient data, time lag in posting data, complex data, political risk and foreign currency risk

c. As below

Step-by-step solution

Explanation of rationale for including international equity into general equity

The primary rationale is the opportunity for diversification.

The three considerations are:

a. Imperfect correlation of business cycle

b. Imperfect correlation of interest rates

c. Imperfect correlation of inflation rates

d. Exchange rate volatility

Arguments against international Equity investment

Three arguments are as follows:

• Un-availability of sufficient data which forms the base of investment decision.
• The time lag in data reporting and comprehending the complex data
• Political risk
• Foreign currency risk

Comparison of the performance and explanation of its significance

From the data of this particular period, it is made out that non-US dollar bonds provided a small incremental return advantage over US dollar bonds, but it was at a very high risk. The fixed income assets unexpectedly outperformed S&P index measure of US equity result with respect to both risk and return. Even the non-US stocks such as EAFE Index outperformed by a good margin with a little risk. In contrast to US equity, it also provided more return for the involved higher risks

The graph shows the position of the Account Performance Index as an aggregate outcome that is superior to the sum of its component parts. This is partly due to the beneficial effect on performance from market diversification and the differential co-variances involved. This way the portfolio manager achieved an on balance positive alpha.

The addition of the international securities to portfolio worked for its advantage.