Sunday, January 20, 2013

Geographical Diversification, Part 2: Answering Ayon's Questions


In this post we go straight to answering Ayon's questions from Part 1.

1. Is the 50% US stock allocation due only to the location of the magazine? If so would it make sense to just switch Phil. Stocks with U.S. (i.e. 50% Phil, 15% US, 15% Foreign Developed)? Or is it truly better to follow the recommendation and put 50% in the US?

From the previous post, we have established that geographical diversification--that is, investing in different markets around the world--can be used to hedge against country- or region-specific risk. If you have already decided to diversify into foreign markets, the next steps are to identify which markets you want to invest in and how much you are going to invest in each market. Ideally, asset allocation/portfolio construction should be based on an analysis similar to the one described in this post, and I'm not sure if the percentages that you mentioned are a result of this procedure or rules of thumb. What I'm (fairly) certain of is that you allocate the biggest portion of your investment in the currency that you earn and consume/spend. Why? Because earning in one currency (say, peso), then investing in another currency (say, USD), and then converting back to the original currency to spend the money entails a significant exchange rate-related cost. Banks (and money exchange companies) earn from currency conversion by buying at a lower rate and selling at a higher rate, as this table from BPI shows:

If you convert from peso to US dollar and back, for example, you effectively "pay" (40.97/40.18 - 1) = around 2% (assuming the exchange rate remains stable), which means your US-based (or US dollar) investment should earn 2% more than a comparable peso investment for the move to make sense. Actually, it's not so bad for the US dollar since it's widely used in the Philippines, so the spread (difference between the buying and selling rates) is not that high. If you take a look at other currencies such as the British pound (7.45%) and the Hong Kong dollar (16.73% !!!), this exchange rate related cost can be very significant. And this is on top of other extra fees that you will incur if you invest in securities from other countries, which I'll discuss in question 3.

Just to clarify, I'm not saying investing in foreign markets/currencies is wrong; I'm just saying that if you earn and spend in one currency, it would be best to invest most of your holdings in that currency to lower your exposure to exchange rate related costs.

2. If ETFs are locally unavailable, and I want to begin passive investing, what's the best alternative I can get?

We don't have ETFs yet. Laws for ETFs, REITs, and even "PERA" provident funds have already been passed, but I think persons-in-charge are still dickering over the details of implementing rules and regulations.

We do have stock index funds, which are "passive" by definition. I discussed a couple that I know of here.

3. What would be the best way to invest in foreign ETFs? A friend mentioned he opened an account with etrade in Singapore, but I'm not sure if that's the best way.

I'm not really sure if one can open an eTrade account from the Philippines; I'm sure I explored it before, and I remember not being able to find a convenient way of doing it. In any case, even if you are able to use eTrade, I'm not sure that it's the best way to invest in foreign ETFs because it charges a commission of 5% for every transaction, as far as I recall. Costs and fees like this, on top of the currency-related cost that I mentioned above, make investing in foreign markets very expensive.

A more efficient and less costly way to diversify geographically is to invest in a locally offered fund that invests in foreign securities. One example is BPI's Odyssey Asia Pacific High Dividend Equity Fund, which if you take a look at its latest report, is heavily invested in countries like Australia, China, Hong Kong, and Singapore. While this method of diversifying geographically also entails additional costs (US dollar denomination, 1.75% per year management fee), it's still better than if you do it on your own--if you can do it on your own.

4. I believe I've got the Fixed Income investments covered in my Balanced fund, but I'm curious to what those Alternatives really connote. 

"Alternative investments" generally pertains to non-stock, non-debt investments such as real estate, commodities, and private equity.

I hope I was able to address at least some of your concerns. Good luck!

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