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The New Global ETF Investor - back to Contents >

Chapter 5:

Managing Country Risk

In the previous chapter, we discussed several steps you can take to reduce portfolio volatility. In this chapter, we will deepen the discussion of managing portfolio risk and, in particular, focus on country risk.

It is hard to avoid risk in our lives. It is all around us every day whether we recognize it or not. The positive way to look at it is that, without risk, there is no opportunity.

You can’t learn to walk or ride a bike without the risk of falling down. You can’t start a new business without the risk of failing and you can’t become President of the United States without the risk of losing the election.

Likewise, in an investment portfolio, the potential risks and rewards normally mirror each other. The more risk you incur, the greater the potential awards. The goal is to realize what degree of risk is appropriate for your situation and build portfolios that reflect this comfort level.

Let’s outline some of the risks that come with investing.

• market risk – prices of securities and fund rise and fall based on supply and demand
• issuer risk – the risk that an issuer of a security will not be able to meet operating expectations or have some other difficulty
• credit risk – the risk that an issuer will default on an obligation
• inflation risk – the risk that inflation will erode the value of an investment
• liquidity risk – the risk that the thinness of a market may lead to volatility in prices
• political risk – the risk that political events such as elections or policy changes may adversely impact the price of an investment
• currency risk – the risk that the currency in which an investment is denominated may negatively impact its value   

You must be constantly aware of these risks without being overwhelmed by them. As Walter Wriston, the former Chairman of Citibank, aptly put it: “the goal is to manage risk, not avoid it”. 

Let’s move ahead with describing eight steps that will help you better manage risk in your portfolio.

Step # 1

Liquidity First

Before you even think of building an investment portfolio, you should set aside about six month of income in a “rainy day” account. This could be put into a money market fund or U.S. Treasury securities. Having this money set aside will ease your mind and allow you to be more open and creative with your growth portfolios.

Step #2    

You must separate portfolios 

As emphasized earlier, you must separate your core conservative portfolio from your growth portfolios. The core conservative portfolio is for the investments whereby your top priority is capital preservation and growth is a secondary consideration. Your growth portfolios are more speculative with capital growth as the primary goal.

Gentle investor, please don’t, as many investors do, try to commingle these portfolios. This can only lead to confusion and a mishmash of a portfolio.

Step # 3

Really diversify your Core Conservative Portfolio 

You need positions in your core conservative portfolio that are likely to offset each other as unexpected events and market movements become a reality.

This is NOT accomplished with ten American stocks from different sectors or a mix of American small cap, mid cap and large cap mutual funds.

Rather the goal is to have some investments that are on both sides of risks. For example,

• currency risk – if the US dollar declines, have some investments in precious metals or denominated in other currencies such as Switzerland or Australia equity or bond funds
• inflation risk – if inflation heats up have some investments that hedge this risk such as timber or Treasury inflation protected bonds (TIPs)
• political risk – if political events or policies in one country take a turn for the worst, it is helpful to have investments in other well developed countries to offset any loss of value
• concentration risk – spread your investment positions over ten or so asset classes with no one area having more than 10-15% of your total core conservative portfolio
• interest rate risk – have some investments that will benefit from higher rates such as utilities or banking as well as in well developed countries where rates are declining.
• equity market risk – have a substantial allocation to fixed income to offset cyclical nature of all equity markets. Have a wide variety of bond funds including some global bond funds.  

Step # 4

Be careful what Countries you pick

It is important to be careful what countries you let into your conservative core and capital growth portfolios. You also need some guidelines to help keep you from getting carried away and having too concentrated a position in a particular country or region.

The following is a list of countries ranked in groupings according to country risk for investors. There are numerous consulting firms that specialize in ranking countries by risk factors including A.M. Best, trading-safely.com and countryrisk.com. I have evaluated their data and used my own judgement as well.

In general, we rate the following factors:

• the stability and transparency of the overall political and corporate governance
• the legal environment, respect for contracts, low levels of corruption, due process and the  rule of law
• the macroeconomic environment including fiscal discipline and currency strength, adequate infrastructure
• political risk including ongoing conflicts and potential conflicts that could financial markets

Keep in mind that the perceived quality of the countries you choose to invest in is the primary but not the only factor. The price or valuation of a country’s stock market is also extremely important. Oftentimes the best time to buy into a country’s stock market is when it is beaten down but there are signs that its economic and political problems will sharply improve.

On the other hand, if you buy into a country’s stock market after a long bull run or at frothy prices, you will likely lose money. This is so regardless of the quality or risk ranking of the country. Just ask any investor who was heavily invested in the S&P 500 index in early 2000. By September 2002, they would have lost 47% of their portfolios value.

The following countries are drawn from the MSCI Europe, Asia & Far East (EAFE) index and the MSCI Emerging Markets Index.

Step#5

Minimize Company Risk by “Buying Countries”

Our “Buy Countries, Not Stocks” for strategy for growth portfolios helps you minimize company risk.  Say you like what’s happening in Japan and ask your broker for some investment ideas.  She gives you three companies and you purchase the stocks. The overall Japanese market moves ahead but one of your Japanese companies has an accounting problem, the second has labor trouble and the third does well. You may be lucky to break even.

On the other hand, you could have minimized this company risk by buying a Japan iShare ETF that tracks the Nikkei 225 and spreads this risk amongst 225 Japanese companies.

No doubt you can make money by smart and lucky stock picking. My question to you is twofold? Do you or your adviser know enough about the companies you are investing in? Is this more risky strategy worth you time and attention?   

Step #6

Monitor Country Exposure

Many investors are attracted to regional funds and broad based index funds and ETFs because of the perception that they are getting broad exposure and spreading their bets.

Be careful to look under the hood of these funds and see where your money is going.  As an example, let’s look at the iShares MSCI Emerging Markets ETF.  It invests in 26 different countries so it is natural to think that you will get broad exposure to all 26 countries.  

However, keep in mind that each country is weighted according to the size of its stock market (market capitalization). This means that 48% of your investment in this fund is going to four countries: South Korea, South Africa, Taiwan and China. In addition, incredibly, 7.5% is going to one company, Samsung Electronics of South Korea.

The same is true for the MSCI Europe, Asia and Far East (EAFE) index. It contains 21 advanced countries but 48% of the money you invest would go to just two: Japan and the United Kingdom. Meanwhile less than 1% would go to Singapore and Ireland!

Step #7

Cut Losses with Trailing Stop Loss Policy

We have all been there. You buy a stock or fund and it appreciates in value rapidly. Then it stumbles and begins to decline. What do you do? Should you buy more, let it ride, or sell?

Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 20% from its high, sell it immediately.

You can than monitor it and get back in at your pleasure. 

Let me give you a good example of this principle in action.  Early last year, we made a small allocation to the India Fund (IF) in our Global Opportunity model portfolio.  After a rise of 70% in 2003, the India Fund faltered in early 2004 losing 22% of its value.  Although we believe in the long term India story, we sold our position. After thinking things over, we purchased the fund again in May and this new position is up 17% through October 2004.

Step #8

Rebalance Your Portfolio

Over time, the asset allocation mix you began with will change.  Hopefully, that 10% allocation to Malaysia in your growth portfolio will grow to 17%. Conversely, that 10% position in Canada may shrink to 7%.

At least annually, you need to make some changes so that you are not overly exposed to countries that have higher risk factors and volatility.  You can accomplish this rebalancing in multiple ways.  One way is by selling some shares of your winners and increasing exposure to under performers.  Another way is to sell portions of positions that do well and accumulating a cash position to be re-invested at the end of the year.

This accomplishes another goal, locking in gains and taking some money off the table. Remember, only a fool holds out for top dollar, especially in the more volatile emerging market countries.

Bottom Line Investment Edge
Principle #7

Follow Chartwell’s eight step program to better manage risk in your portfolio and to help you build a balanced, well diversified and safer global portfolio.

Next Chapter >

Carl Delfeld
Investment Advisor

• ETF Specialist with Union Bank of Switzerland

• U.S. Representative,
  Asian Development Bank

• Forbes Asia Columnist

• Stockbroker in Tokyo, Hong Kong & Sydney

• U.S. Treasury consultant

• Graduate of Fletcher School of Law & Diplomacy

• Fellow at Keio and Sophia University, Tokyo, Japan

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