alian share market has been punching above its weight in recent years, leaving Australians with little need to look overseas for investment opportunities. But all prize-fighters have their day, and while the outlook for both Australian and international shares is uncertain, it makes sense to spread your risk and wage a small bet on global equities. For most people, the easiest way to do this is to invest in an international equity fund.

In the 12 months to May 31 when the Australian market returned 23.5 percent and global equities (measured by the MSCI World Index) returned 4.8 percent, the top 10 international

funds returned more than 12 percent. Over three years, which is a more reliable measure of fund performance, seven of the 10 convincingly outperformed world markets, which fell 2.5 percent.

Most pundits expect the returns from Australian shares to be more muted over the next 12 months, encouraging professional investors to take a closer look at the alternatives. A recent survey of 43 investment managers by Russell Investment Group found that most believe international equities will be the strongest performer over the next 12 months.

A market veteran and independent consultant, Don Stammer, insists the "investment arithmetic" for global equity markets is not stretched. Overseas markets have recovered from their low of 2003 but they have not climbed to record levels, as Australian shares have. He believes share valuations are comfortable rather than stretched, in Australia as well in the US and Asia. Stammer considers the big risk to global markets over the next 12 months is unpredictable events in the Middle East. "The biggest unknowable is exchange rates," he says.

"Unforecastable" is how Hans Kunnen, the head of investment markets research at Colonial First State, describes the Australian dollar, but he agrees that much depends on it. If commodity prices hold up then the Aussie dollar should do too, but if the US increases interest rates, attracting global capital away from competing currencies, then our dollar could come under pressure. Because of this exchange rate uncertainty and the fact further rises in the Aussie dollar will reduce returns of global funds when they are converted back into Australian currency, Stammer says it is important to choose a fund that can hedge.

The importance of hedging in the current market is demonstrated by the dominance of hedged funds in the accompanying table. While the fully hedged version of Invesco's Global Matrix Fund was up almost 19 percent, the unhedged version - which is identical in every other way - returned 11 percent.

In terms of regional markets, Stammer has a slight bias to Asia with the exception of China. He believes the scheduled tightening of monetary policy in the US is factored into the market, while in Europe, he says, companies are performing better than economies. Kunnen points out that despite all the talk about China, its share market fell 25 percent over the past 12 months and compares this with India, where shares rose 50 percent. "This highlights the volatility in emerging markets; investors need to be wary," he says.

Kunnen says the US is showing good resilience, Japan is showing signs of life and he is neutral on Europe, although he observes that European companies are doing well by focusing on export markets and cutting costs. This is borne out by Equity Trustees's Intrinsic Value Fund, one of last year's star performers, which invested almost exclusively in European markets.

It's possible to buy funds that focus on a region or a global industry sector such as biotechnology or listed property, but for a core international shareholding it makes sense to begin with a diversified fund with the ability to invest across a range of markets and sectors. Even then, there are choices to make. No one style of fund prevailed last year. The top two funds are globally diversified but they were followed by two resources funds, reflecting the global commodities boom.

Index funds, which passively track a market index rather than actively pick stocks, also held their own, with four in the top 10. With fees significantly lower than their hyperactive rivals..., they continue to offer value for money.

Questions:

1. Explain the logic behind investing in international share funds as against only

investing in domestic stocks.

2. Outline why it is important for firms to hedge their exposure.

3. Explain the approach of index funds and its advantage.

(40 marks) (30 marks) (30 marks)

Australian