Across client portfolios which include an allocation to international equities we have made the following changes:

Sold

• iShares S&P 500 exchange traded fund (“ETF”) which seeks to track an index of large-capitalisation U.S. equities;
• iShares MSCI BRIC ETF which seeks to track an index Brazilian, Indian, Russian and Chinese equities that are available to international investors; and
• iShares Asia 50 ETF which seeks to track an index of 50 of the largest Asian equities.

Bought

• iShares MSCI EAFE ETF which seeks to track an index of large- and mid-capitalisation developed market equities, excluding the U.S. and Canada; and
• Macquarie Asia New Stars No1 Fund (“MANS Fund”), an actively managed fund offering investors exposure mid-and small-capitalisation equities in Asian countries (excluding Japan), with a focus on quality and growth.

The purchase of the iShares MSCI EAFE ETF was funded from the sale of the iShares S&P 500 ETF, as the view of the investment committee is that while the US economy has entered into a sustained economic recovery, the combined effects of record high margins (in part due to more savage cost cutting by companies than global peers), better corporate earnings growth and extremely accommodative monetary policy has seen US equity markets rerate to levels where the good news is now fully factored into current valuations.

While valuations in Europe have also expanded over the past 2 years, the region is at a much earlier stage of its economic recovery than the US – Europe only exited recession in 2Q 2013 – with macro momentum improving. We see more upside to still depressed margins and earnings in Europe, and unlike the US where monetary stimulus is being wound back, in Europe further stimulus is possible given concerns around deflation.

Japan meanwhile has underperformed the US market by around -13% (in USD) in 2014 following the strong “Abenomics” rally in the latter part of last year. As a result the Japanese market is now trading at a discount to global equities on a forward P/E basis, with earnings expected to be supported by further BOJ stimulus and a weaker Yen. As the most cyclical major market globally, Japan offers high operational leverage to a wider global recovery which is our base case scenario.

In essence, with the US trading at a valuation premium despite further earnings growth expected to be tougher to achieve with margins at cyclical peaks, and monetary policy more supportive in other developed markets we expect the US equity market will underperform going forward.

Turning to the switch from both the iShares Asia 50 and MSCI BRIC ETF’s into the MANS Fund, we do expect that in the year ahead performances across emerging markets will diverge as investors increasingly differentiate between countries depending on their underlying fundamentals rather than simply viewing emerging markets as a homogenous block trade. To illustrate, a country like Brazil is expected to underperform as it grapples with twin deficits (i.e. both budget and current account deficits), a phase of interest rate hikes and upcoming elections which are raising doubts amongst investors in the government’s willingness to implement much needed prudent macro policies ahead of the presidential elections in October. As such we decided to sell the iShares MSCi BRIC ETF which as a passive index tracking fund would allocate to a country like Brazil regardless of the fundamentals.

Looking then at where to invest the proceeds from the IBK sale, we believe that Asia (including both developed and emerging countries) currently offers exceptional value. Despite being a beneficiary of improving global growth, the region has lagged in terms of market performance over the last six months. Fears around the impact of slowing rates of growth in China meant Asian markets have also not enjoyed the PE rerating like other regions, such that both absolute and relative valuations are compelling for patient investors. As illustrated below, on a relative valuation basis Asian markets have de-rated significantly versus global markets over the past year and are now approaching extreme levels.

While the iShares Asia 50 ETF does provide exposure to Asia, it is however limited to only the largest 50 Asian companies in a region with an investable universe in excess of 4,000 companies. The larger capitalisation stocks which dominate the indices are typically more exposed to the financial, property & technology sectors, while our preference currently is for increased exposure to companies focussed on the emerging middle class consumer and positioned to benefit as these economies with young and growing populations transition from infrastructure led to consumption led growth, a theme already underway and which we believe will continue to play out over the years ahead.

The iShares Asia 50 ETF also does not include countries like the Philippines, the second fastest growing emerging market economy which is not being driven by debt funded investment growth, or Thailand which is enjoying the tailwinds of pro-growth monetary policy and a more competitive Baht.

We decided to also sell the iShares Asia 50 ETF and instead invest in the actively managed MANS Fund which allows the manager to allocate between the various Asian developed and emerging markets depending on where they see the greatest value and taking into account the countries underlying economic fundamentals.

As illustrated below, the MANS Fund’s portfolio positioning also enables us to play the consumer thematic much more aggressively than we can via the iShares Asia 50 ETF which has no allocation to healthcare and less than 11.0% to the consumer discretionary sector.

A much greater proportion of the companies in the consumer discretionary and healthcare sectors are however small to mid-capitalisation where corporate governance and accounting practices are not of the same standard as in markets like Australia. In this region it is imperative to have an overriding emphasis on corporate governance and asset quality which the manager of the MANS Fund does have – this focus on quality is demonstrated by the portfolio characteristics vis-a-vis the market indices which illustrates stronger growth, higher ROE and less debt. While there is obviously no guarantee that past performance will be repeated, since inception of the MANS Fund the focus on growth and quality has been rewarded.

Good liquidity in the underlying holdings is also important and allows the MANS Fund to offer daily liquidity to its investors.

An experienced team of 8 members enables the manager to conduct over 500 company visits a year to verify their fundamental research, and in a region where companies are less well researched by institutional investors, there is a greater probability of them uncovering compelling opportunities at an individual stock level than in the better researched developed markets like the US or Europe.

The combined impacts of the aforementioned changes are reflected below.

While perfectly timing investment switches in the short-term are near impossible, we do believe that valuation differentials will win out over the long-term, and that patient investors will be rewarded as a result of the changes made.

Disclaimer

EP Financial Services Ltd

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