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Think-thank: Foreign markets may have appeal, but watch out

Investors looking to shift out of North American equities this year and employ those powerful loonies overseas, be warned: There’s a world of trouble out there that could make Alberta’s royalty review look like a rained-out picnic.

New York-based Eurasia Group, which monitors and measures risk through its annual Global Political Risk Index, says resource-rich regimes - such as Russia and Venezuela - are increasingly leveraging record high commodity prices for political gain. “A number of countries are using their economic assets as tools of political policy,” says Eurasia Group analyst Willis Sparks, who cautions investors to pay special attention to the trend. “We’re looking at a backlash against globalization this year.” Over all, there’s little change in this year’s Global Political Risk Index compared with previous years, but there is a noteworthy shift away from political stability toward economic stability.

The assassination of Pakistan opposition leader Benazir Bhutto and recent election-related rioting in Kenya are the most recent examples of political upheaval in the developing world, but Willis says the books in those countries appear to be in order. “We see healthy account balances and healthy fiscal balances.” With the subprime anvil tied to equity markets in the developed world it’s easy to see the appeal of developing markets. While the Dow industrials inched up 4.6% last year, the MSCI Emerging Markets Index steamed ahead 33.4%. India, Brazil, Turkey and Indonesia advanced more than 40% while Chinese equities nearly doubled.

Investing in politically safe foreign equities is an incredibly tricky game. Most money managers say the best course of action is diversification and the way to spread risk around is through actively managed mutual funds or passively managed exchange-traded funds (ETFs). There are several country- or region-specific funds (such as Asia-Pacific and emerging markets) with a mix of sectors. There are also more broadly focused international equity funds with the potential to include the entire world outside of North America. “It’s difficult, if not impossible, to quantify political risk. It can shift very quickly,” says Franklin Templeton Investments president and CEO Don Reed. His $2.5-billion Templeton International Stock Fund holds stocks based on bottom-up fundamentals such as an individual company’s management team or balance sheet. Macro considerations such as political risk often take a back seat, but Reed says his fund is subjected to regular peer reviews where research groups run screens on holdings to assess all risk.

Most of the companies in the fund are based in regions such as Europe and Japan, but he says that doesn’t exclude them - or even North American-based companies - from political risk. “If it happens that they’re doing 90% of their business in a country where the economy is very bad, that’s probably more important than how well the company is managed,” he says. The Templeton International Stock Fund generally holds companies for five years, and according to Reed that gives good fund managers plenty of time to react to short-term political volatility. “The political environment in the vast majority of cases can’t change things overnight,” he says. ETFs, on the other hand, don’t have the luxury of an active manager to steer clear of political trouble. Fees are normally much lower than mutual funds but holdings are tied to an index and investors are at the whim of the broader market.

However, ETF advocates say it makes little difference when it comes to the frugal nature of politics. “Active money managers and passive money managers get hurt by the same political risk,” says Claymore Investments CEO Som Seif. “I’ve never seen an active money manager with the skill to get out of a nation prior to political risk and make the right call all the time.” Claymore offers a variety of index-linked funds that include emerging market equities and what are termed the BRIC countries - Brazil, Russia, India and China. Seif says the tradeoff for political risk over the past year has been generous rewards. “Political risk is already priced into the market,” he says. In addition to free-market risk management, Seif says many ETFs have built-in risk controls. As an example, he says the Claymore BRIC fund only holds stocks that are listed in the United States and subject to regulatory controls by the US Securities and Exchange Commission.

Willis Sparks at Eurasia Group refuses to weigh in on the mutual fund versus ETF debate but he does stress that professional money managers have little to no advantage over individual investors when it comes to anticipating political action. “I think every foreign investor needs to be better educated about political risk,” he says. “Markets are not a good indicator of political risk, and that’s why we exist.” (