J.P. Morgan

4 G E O G R A P H I C A L A N D S T R A T E G Y D I V E R S I F I C A T I O N S T I L L M A T T E R The norm Wide dispersion in geographic performance is the norm. Geography, therefore, is always a key ingredient in an allocation mix. However, the 2013 markets drew investors' attention to the essential question, "What is an appropriate weighting within an equity allocation?" The size of a country's economy, historical growth rates, and the growth dynamic of local industry and companies are no guarantee for public market investors achieving the return associated with equity risk. Still, some equilibrium derived from long-term assumptions and intermediate conditions should be considered the starting point for a discussion about geographic allocation. Strategic equity weightings are essentially a 10-year-plus proxy for capturing economic growth, market valuation anomalies and potential execution alpha. They also provide a measure of diversification. The belief that one might effectively and efficiently capture global growth, valuation and diversification benefits was put to the test in 2013, when developed and developing markets' performance substantially diverged. Indeed, the gap became so wide, it was reminiscent of the return differentials of 1997–1998, the years emerging Asian markets imploded even as the United States was in the heady rush of a full-blown "irrational exuberance." Return dispersions between individual country market performances in 2013 were even more extreme. For example, the United States gained 32%, while Brazil fell by 16%. One year does not validate or invalidate a strategic allocation. Still, it can be very challenging for investors to live through protracted regional underperformance, waiting for the perceived fundamentals to emerge. (See "Exhibit 2: How patient an investor are you?," page 11.) A tactical allocation may help smooth the path of relative performance during a year like 2013. However, the core of a reliable plan is to establish a long-term allocation informed by current equilibrium conditions, specific regional and country anomalies, forward-looking assumptions, and an appropriate risk profile conducive to achieving an institution's objectives as efficiently as possible. So, how should we work toward that goal? Out of sync First, it is important to recognize that economic activity/growth and equity opportunity are often materially out of sync for extended periods of time. We start with a commonly held, simplistic premise that gross domestic product (GDP) provides the raw material for an equity investment allocation. This reference point helps investors begin to size equity opportunity across countries and regions particularly if framed in terms of share of global economic activity versus the rest of the globe. Of course, static GDP weights are only one means to orient and begin the conversation. Growth of GDP, public market valuation of that growth, and risk around growth and valuations become more important as the size of the investment potential increases. However, it is useful as a starting point to examine "gross" economic activity to help put the allocation exercise in perspective. Even a large, growing and attractively valued equity opportunity may offer less to investors than meets the eye. Investors also need investment vehicles to capture equity opportunities; yet many countries' public equity capitalizations are distorted vis-à-vis the size and nature of their economic activity. QUESTIONS AT THE CORE OF THIS CONVERSATION 1. Why does geographic diversification matter? 2. Are you looking through the strategy to the underlying source of risk? 3. How important is execution strategy? 4. Are there any risk exposures inconsistent with the expected outcome? 5. What are the potential consequences of a large home-country concentration?

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