The advantages of international investment are undeniable: diversification, higher potential returns, risk spreading… But is it really that simple? There is mounting disagreement over the best way to invest.

International mutual funds are as popular as ever. And for good reason! “Why should I invest all my assets in Canada? International diversification corresponds to superior growth opportunities,” comments Patrick Frigon, General Manager Sales of Quebec at AIM Fund Management. “We’d rather be masters of the universe than maîtres chez nous!”

There are many factors that propel investors beyond our borders, Mr. Frigon says. The lacklustre average performance of the Canadian stock market for the past twenty years is one clear incentive. Also, the dependence of our economy on natural resources (a bone of contention among economists), and its cyclical nature are driving investors to seek greener pastures.

Scott Barlow, a mutual fund analyst for Merrill Lynch agrees. “Investing uniquely in Canadian funds means turning your back on over 90% of the rest of the market,” he says. Yet in the same breath, Mr. Barlow advised investors to be cautious and avoid concentrating their assets. “I don’t believe that you have to invest uniquely in Canadian funds or in international funds.”

Two schools of thought

That being said, international investment choices are increasingly polarized between proponents of sectoral diversification and adherents of geographical distribution. In fact, “buying” in Europe, Asia, the United Sates (or several regions at a time), a long-time preferred strategy of fund managers is now giving way to investment in industrial sectors.

Many turn to industrial sectors to maximize the risk-return ratio. Evidently, managers believe they can realize identical returns to those generated by geographical distribution of assets, but with less risk.

In an exhaustive study published last September by the Financial Analysts Journal, a team of three specialists compared the approaches over a 13-year period, from 1986 to 1999. Twenty-one countries and 400 international investment funds were analysed. The researchers found that sectoral diversification offers superior returns coupled with a reduced risk. In addition, deregulation of international trade barriers and the creation of groups such as the European Economic Union (EEU) have sent international mutual fund managers back to the drawing board.

Mr. Frigon of AIM is a firm believer in sectoral division. “Geographical distribution doesn’t work as well as it used to. Large companies are already present on the global level; their business is distributed across several world regions. That is why we adopt a sectoral approach,” he explains.

One example of the de facto control industrial sectors wield over the investment world can be found in Nortel Networks stock. Managers who want to compare this technology heavyweight with its peers don’t look at other large Canadian companies (Canadian Pacific, Bombardier). Instead, they examine world-class companies that operate in the same sector, several managers told The Insurance Journal.

“If I invest in Nortel, I also have to watch Cisco and Lucent. If I include Nokia in my portfolio, I have no choice but to also look at Ericsson and Motorola,” Mr. Frigon says.

AIM bases its investment decisions on seven sectors: technology, consumer products, health care, financial services, natural resources, telecommunications and infrastructures.

According to Pierre Lapointe of Laurentien Bank Securities, the heightened integration of global economies is the clarion call for sector-based management. “We must increasingly focus on sectoral diversification,” he says. But the strategist is still not ready to totally abandon geographical diversification, an avenue that has been highly popular and advantageous for the past two decades.

Mr. Barlow explains that up until recently, sectoral distribution was quite popular at Merrill Lynch. But the recent plunge in technology stocks has changed people’s minds. Now the geographical distribution model is looking better than ever. The analyst reports that he is watching Europe, while keeping a close eye on the economic slowdown in the United States.

“Many of our funds are still managed by geographical distribution,” says William Sterling, Global Strategist at C.I. Fund Management. Three factors underpin the choices of the firm’s international fund managers: industrial sector, the political context of the main country in which the company operates and the currency involved.

At Elliott & Page, a subsidiary of Manulife Financial, the manager of the E&P Cabot Global Multistyle Fund, Richard Crook, remains decidedly geographical in his approach. Together with his management team in London, where we contacted him, Mr. Crook divides the globe into four blocks: Europe, Asia, United States and Japan. “We do not consider every country in the same way. Region-based management methods will let us generate worthwhile returns,” he says.

Mr. Crook evaluates economic, social and political factors specific to each geographical region. “If we overweight Europe, it’s because we believe that our management style will let us outperform benchmark indices.”