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Investors Shift to International Equities in Search of Higher Returns

Diversification and a desire to move into other equity classes sparked a turnaround in international equities during the first quarter.

Investors regained their appetite for international stocks during the first quarter of this year, according to financial data firm eVestment.

Investors added a net $8.1 billion to their holdings of non-U.S. international equities in the first three months of 2014, a sharp reversal from the second half of 2013, when they withdrew a net $42.6 billion from international equities, says the Marietta, Georgia–based firm, which tracks 53,000 funds around the globe.

Behind the turnaround in money flows is a desire by investors to diversify their equity allocations and find alternative equity asset classes with higher potential gains, according to Todd Rosenbluth, director of mutual fund research at S&P Capital IQ in New York. “Given how the S&P 500 index did in 2013, many investors wanted to reallocate their exposure to other investment styles,” Rosenbluth says. “Even though we’ve seen the U.S. stock market move higher in 2014, I think the expectation coming into the year, and still throughout the year, is that duplicating that 2013 success in 2014 is unlikely.”

The world of equity funds is about equally divided between U.S. and non-U.S. funds, by assets. During the first quarter of this year, for example, non-U.S. equity funds held 49 percent of the $9.39 trillion of equity fund assets tracked by eVestment. This compares with $4.96 trillion in non-U.S. equity funds in the fourth quarter of 2013, 48 percent the total $10.33 trillion value of all equity funds. It also compares with $4.74 trillion in non-U.S. equity funds a year earlier in the first quarter of 2013, 50 percent of the total $9.43 trillion value of all equity funds.

Although investor attitudes toward international stocks have shifted, the investor stance toward the U.S. market has remained remarkably consistent for nearly three years. Investors have — whether as a result of the need to reallocate outsize gains or because of a desire to further diversify allocations into other equities, fixed income or alternative investments — steadily reduced their net exposure to funds invested in U.S. equities. Investors withdrew a net of $40.3 billion from U.S. equity funds in the first quarter, marking the 11th straight quarter of reduced U.S. equity allocations totaling $581.4 billion going back to the third quarter of 2011, according to eVestment.

As investors moved into non-U.S. equity funds in the first quarter, they favored funds with general, flexible investment objectives. “The broader and more diversified the fund, the more likely it gathered assets,” says Rosenbluth. A deeper dive into the eVestment data confirms that view. For example, funds that invest in any non-U.S. equity around the globe had net new inflows of $3.79 billion in the first quarter. Such funds hold $1.41 trillion in assets, making it the largest category of non-U.S. equity funds.

The first quarter also saw large net inflows into Europe, Australasia and Far East (EAFE) equity funds. “In the same way the Standard & Poor’s 500 index or large cap core or large cap blend tends to be the first place investors start when getting exposure in the U.S., EAFE equity tends to be where they run to or from when changing allocation internationally,” says Rosenbluth. During the first quarter, EAFE funds received $4.35 billion in net new flows, a sharp reversal from the $21.7 billion in net outflows in the second half of 2013.

Investors put a net $2.68 billion into all-Japan equity funds in the first quarter, $852 million into all-Europe equity funds and $239 million into all-Australia equity funds. Another broad category, all-country world index (ACWI) equity funds, excluding the U.S., got $2.31 billion in net new flows.

It is not just U.S. equities that saw net outflows in the first quarter of 2014. Investors have also shifted assets out of other developed markets that have experienced big returns in recent years. For example, there was a net shift of $3.72 billion out of funds invested entirely in U.K. equities and a $1.97 billion net reduction in allocations to funds that invested only in Canadian equities, according to eVestment.

The returns on international equity in recent years, although not up to the outsize 29.6 percent gain by the S&P 500 in 2013, have still been attractive by historical standards. The MSCI index for all countries except the U.S. has risen 31 percent over the past two years.

The $2.42 billion Thornburg International Equity Growth Strategy fund, run by Santa Fe, New Mexico–based Thornburg Investment Management, has tapped into the higher returns that investors are seeking in broadly based non-U.S. international equity funds. “It is an all-cap international growth fund that can invest in any equity, regardless of market cap, in any country around the world,” says Tim Cunningham, portfolio manager and managing director at Thornburg. “We like the flexibility. Anytime you limit the stocks you can buy, it limits your performance.”

In the year ending March 31, the Thornburg International Growth Strategy, of which Cunningham is a co-manager, returned 18.2 percent, handily beating the 10.8 percent return of its benchmark, the MSCI ACWI ex USA Growth index, according to eVestment data. The fund has the rare distinction of being in the top one percentile in performance among its peers on a three-, five- and seven-year basis. Its best performance is its five-year return of 26.9 percent, compared with 18.4 percent for its benchmark.

One of the Thornburg fund’s high performers is online electronic payments processor Wirecard of Aschheim, Germany, just outside Munich. The fund added Wirecard to the portfolio in 2012 because it fit Cunningham’s key criterion for an international growth stock: It has high margins with a good cash flow. It has “a nice long runway of growth,” Cunningham says. And it was priced at a reasonable valuation. In 2013 Wirecard had €83 million ($111.8 million) in net earnings on €482 million of revenues. The company reported net profits of €35 million in the first quarter of 2014 on revenues of €126 million. As of July 18, Wirecard’s shares had risen 34 percent during the past 12 months.

Investor interest in international equities is also reflected in the level of search activity within the eVestment database. Of the top ten searched categories of funds in June 2014, nine are classified as non-U.S. international equity funds. And eight of the top ten individual funds experiencing the most search activity in June were also non-U.S. international equity funds. Heightened search activity is often followed by corresponding shifts in asset allocations in subsequent quarters, according to Rich Donnellan, product manager at eVestment. “The trend is that we are going to see continuing inflows into international equity strategies, based on everything we’re seeing,” says Rosenbluth.

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