Individual investors continue to pile into global stock funds while comparatively ignoring domestic stock funds.  Considering that global giants dominating the market cap weighted U.S. domestic indices have strong non-domestic revenue and profits streams, we continue to be surprised by the magnitude of the imbalance.

At the same time that most allocators are recommending lower weights to international than to domestic stocks, the new money is overwhelmingly going global.  That demonstrates a rather wholesale shift in allocation policy by retail investors.

The two charts below demonstrate the flows clearly.  One shows the flows to global stock funds, domestic stock funds and total stock funds for discreet calendar years.  The other shows the 3-month rolling average flows.  (”global” in these data include both international [non-US] funds and global [international + domestic] funds).

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(Data from Investment Company Institute)

You may not be a mutual fund investor and wonder why mutual fund statistics are useful to you.  You may prefer individual stocks (including ADRs) or ETFs. 

We use use mutual fund data for several reasons. First, the data is available.  Second, mutual funds are good indicators of trends in investment cash flows, because the data is long-term.  Third, in spite of ETF mania and ADRs, mutual are still the major retail investment vehicle and account for a huge share of total investment flows.

It is important to note that mutual funds are principally a retail product (including 401-k accounts) and do not necessarily indicate anything about pension funds, endowments and other non-retail flows.  I am not suggesting that institutional money is flowing differently — just that the retail data offers no information about institutional flows.

For those of you working with ETFs, you could probably think of these charts in terms of SPY or IWV for domestic funds, and EFA in combination with EEM or VWO for “global” funds.  There is not much in the way of liquid global ETFs that include both domestic and non-domestic stocks.

Richard Shaw
QVM Group LLC

Disclosure:  Author owns VWO, EFA, and IWV 

One of our clients who invests substantial amounts in individual tax exempt municipal bonds asked us how municipal bond issuers assure that they will have the investment interest available to pay the bond interest rate due during the time between the bond issuance and the time the money is put to its public purpose. In other words, how do they match assets and liabilities for temporary investments before they must rely on tax revenue to pay bond interest?

For most people, even municipal bond investors, the question is a bit esoteric, but it is also of potential interest to town, city and state officials and legislators who may not be directly involved in the bond process, but who are concerned about the very question.

Our firm is actually involved in helping governments select investment solutions to solve that very asset and liability matching problem. Here’s how it generally works:

Let’s say a city issues a long-term tax-exempt bond for 10’s of millions of dollars to build a school, road, bridge, sewer plant, or some other public facility. When they issue the bond, they get all the money at one time, but they will not disburse the money immediately, and will pay it out in stages as the project is completed in stages. They will have a development schedule and a disbursement plan, but life being the way it is, reality and plans are seldom exactly the same. The city has a need for a delayed and periodic but irregular and not entirely precisely timed future of making payments toward the development project.

Therein lies the problem. The bond calls for just the opposite — immediate, periodic, regular and precisely timed payments of interest at a fixed rate. How does the city avoid the risk of having to use tax revenue to pay any portion of those interest payments before the money is disbursed for the public project?

The solution is a flexible withdrawal, guaranteed investment rate contract from an institution that can manage the cash flow vagaries of a flexible withdrawal feature. The city gets the bond money in and immediately invests it in such a flexible GIC.

Examples of companies that provide flexible GICs for this purpose include: AIG, Citicorp, Morgan Stanley, Bank of America, MBIA, Berkshire Hathaway, and others.

The law limits the vehicles available for investment of municipal bond cash, to rock solid things like U.S. Treasuries. Therefore, the alternative to the flexible withdrawal GIC would be for the city to build its own Treasury ladder, but then they would have other risks — market risk if cash were needed before rungs on the ladder matured, or reinvestment risk if rungs of the ladder matured before cash is needed. The flexible withdrawal GIC eliminates both of those problems.

Bond issuers may have internal staff to analyze GIC bids to select flexible GIC providers, or they may call on advisors, such as our own firm, to analyze the proposals from various GIC providers bidding for the investment. That analysis makes sure that the detailed terms of the contracts, which are complex documents, actually respond suitably to the bond issuer’s needs and specifications. It organizes the various formats of data from the bidders to allow a meaningful side-by-side comparison of the bids. The investment advisor then recommends which of the bidders is the best choice for the city. Finally, the advisor coordinates activities to make sure that the winning GIC bidder gets the contracts issued timely and in conformity with the bid proposals.

The story is not yet over, however. The Tax Reform Act of 1986 created an effective 100% tax on excess interest earnings in repurchase agreements by municipal bond issuers. Simply put, if the GIC pays more interest than the municipal bond pays out, the bond issuer must surrender (rebate) the excess to the U.S. Treasury. However, if the GIC pays less interest than the municipal bond pays out (and that happens in some circumstances) the bond issuer is just out of luck and the U.S. Treasury does not refund prior excess payments. There are some rules that allow offset between a current losing GIC and a current winning GIC, but the noteworthy fact is that the Treasury generally intends to share in the bond issuer’s reinvestment profits, but stand back from its losses.

As a result of this federal regulation, the Internal Revenue Service issued IRS 26 CFR Part 1, Section 1.148-5, which allows municipal bond issuers to deduct the cost of advisors in the GIC selection process from any calculation of excess interest that the bond issuer may be liable to pay the U.S. Treasury. That is why the GIC providers are the ones who are now required to pay the advisor to the bond issuer. It keeps things nice and simple for the bond issuer to receive interest net of the advisory fee before it figures out if it owes Uncle Sam money

That is how governments manage temporary municipal bond investments to match assets and liabilities.

Richard Shaw
QVM Group LLC

Disclosure: Author does not own any of the companies listed.

A reader commented to us about our recent article on a market cap approach to asset allocation.  That reader made a good observation that market cap should not be used alone to make allocation decisions, and we agree totally.  We should have chosen a different title for the article and should have explained adequately that market cap is only one tool in the allocation toolbox and not a sole guide to allocation.

The article basically pointed out that the world markets have grown to the point that the U.S. no longer accounts for even ½ of world market capitalization.   While the U.S. market is still the largest market, it is not as overwhelmingly large as it once was. 

The article also pointed out that even though U.S. investors have dramatically increased their non-domestic allocations, that reallocation has not changed as rapidly as the change in relative sizes of national stock markets.  Part of phenomenon is inertia, part of it is lack awareness of the scope of non-domestic opportunities, and part is concern over various risk factors associated with investing overseas, such a currency risk, and in some cases political risk, liquidity risk, regulation and transparency risks, and more.  However, the situation has steadily improved and foreign opportunities have expanded.

Investors need to keep in mind that the world has been globalizing in many dimensions.  It many not make sense to live in a world of foreign energy sources, outsourced data processing and call centers, and offshore manufacturing, while at the same time tightly confining one’s portfolio investments to domestic companies.  Admittedly, the major U.S. companies are global players and investing in something like the S&P 500 (SPY) or Russell 1000 (IWV) buys a lot of foreign operations and sales.

In fact, we issued a premium research study last year based on 2005 annual reports of the 100 largest market cap companies in the S&P 500 which found that in the aggregate 25% of their revenue came from non-domestic sources.  In fact, the top ten derived 75% of their revenue from non-domestic sources.  The second ten derived 60% and the third ten derived 50%. 

An argument can be made for investing only in global giants (mostly coming from the U.S. and Europe).  A long-term chart (shown below) illustrates US companies (proxy SPY or IWV) outperforming EAFE developed country markets (proxy EFA) and emerging markets (proxy EEM or VWO) from 1992 through today. 

  [click image to enlarge]

We don’t know which came first – the chicken or the egg, but the largest companies have the most global operations.  We suspect they are that big first because they are excellent, but next because they made the effort to extend themselves overseas. 

Similarly, we think to be truly successful in the stock markets today, you need to be first excellent and then extend yourself globally.  And, here’s where our reader’s comment comes in – we forgot to talk about the excellence requirements that would govern when, where, how and how much you extend globally.  You need to develop and utilize the classical fundamental and technical analytic tools on which investing is professionally grounded, whether investing domestically or internationally.

Even though the US is the largest market, a medium-term chart of 3years (shown below) illustrates the recent outperformance of the rest of the world compared to the US.

   [click image to enlarge]

Could the US return to performance supremacy?  Yes.  Do we think that is likely to occur in the next 12 months?  No.  Do we think trees grow to the sky?  No.  Do we think chasing the hottest markets is the best course? Probably not, if risk is also considered along with potential return, but not all foreign markets are overheated relative to the US.

The long-term and short-term charts points to the importance of “money flow”.  We think it’s important to follow the money, but don’t follow it over a cliff.  Learn to recognize the difference between finding the party and staying too long and drinking too much.  Fundamental and technical tools will help you do that.

Examining world market cap trends will show you where the money is and how it is moving.  Fundamental and technical analysis will tell you where and how it is likely to move in the future and when, where and how much you should commit to any market.  You need keep all those things in balance to avoid loss and prosper.  

Richard Shaw
QVM Group LLC
Registered Investment Advisor

Disclosure:  author owns IWV, EFA, and VWO