Morningstar's "Perspectives" series features investment insights from third-party contributors.
There’s no place like home, apparently: research shows that most investors tend to bias their portfolios in favour of their home country. This means their portfolios hold a higher percentage of investments from the country they live in than the market-cap weighting.
For example, as of December 2014, UK equities accounted for 7.2% of the overall global equity market. If an investor wanted to invest proportionately in the global market, they would hold only 7.2% of their equity portfolio in British stocks. However, British investors collectively held 26.3% at the year-end in 2014.
This phenomenon is not unique to the UK. In fact, the tendency is even stronger among American, Canadian, Australian and Japanese investors. Why do investors display such a strong bias towards their home countries and is it as simple as ‘sticking to what you know’?
Typically, portfolio bias is made for two major reasons: return expectations or risk mitigation. Home bias can be an unintended result of constructing a portfolio incrementally over time, but there are a few key reasons investors choose to bias their portfolio in favour of their home country.
Expectations
Investors’ expectations for future returns in their home market are a key factor – if investors feel positively about their home market, they will choose to invest more in it. Research shows that investors tend to be more optimistic about their domestic economies than foreign investors are.
Preference for the Familiar
Investors generally feel more comfortable with their home market and allocate investments accordingly, even if it results in a poorer risk/return trade-off for their portfolio.
Corporate Governance
Corporate governance practices have a major impact, with investors from developed countries tending to favour their own markets, where corporate governance is more robust. Higher costs to access foreign securities may also encourage greater domestic investment.
Liability Hedging
The need for some institutional investors to hedge certain liabilities may lead to a home-country bias, especially in fixed income, but also perhaps in equities. This is because it is easier to fund a clearly defined liability using assets that move in tandem with those liabilities. Similarly, domestic investor spending is often influenced more by domestic inflation and interest rates than overseas data. In these instances, the diversification benefits attained through adding foreign assets may actually decrease the portfolio’s ability to meet its objective.
Multinational Companies
Investors may feel that through investment in multinational companies, they will attain as much global diversification as they will need. But as global economies become more interconnected, it’s important to consider the extent to which investment in domestic companies provides exposure to foreign markets.
Currency
Many investors perceive foreign investments as inherently more risky than domestic holdings. For example, it is not uncommon to see investment providers’ websites or literature list foreign equities among the riskiest assets, despite the well-documented diversification benefits of including foreign securities in a diversified portfolio. Much of the volatility in foreign investing can be attributed to exchange-rate fluctuations, and the desire to avoid the influence of such movements could be an additional reason why investors allocate greater percentages of their portfolios to domestic securities.
So how much home bias is acceptable and how can investors find the right balance between domestic and foreign securities? Home bias has certain implications for a portfolio, mainly risk, return and cost-related, that investors should be aware of. Investors should evaluate whether their responses to these considerations mean the amount of home bias in their portfolios needs to be reduced.
Return Expectations
Returns over the near term can vary by country. If an investor has a strong conviction that returns will be better in one market than another, they may choose to tilt their portfolio. But future returns are difficult to predict and will differ by country, so global exposure is a valuable approach.
Risk Mitigation
An investor’s home country is likely to have a more concentrated composition than the global market, leading to sector and issuer risks. For example, as of October 2016, the top ten constituents of the FTSE All Share Index have a combined weight of 35% whereas for the FTSE Global All Cap Index, the figure is 7.93%. Investors interested in dampening concentration risk in their portfolios may wish to diversify further by investing globally.
Transaction Costs and Liquidity
Investment costs include direct transaction costs, taxes and market impact costs. Investors in costly or generally illiquid markets may benefit significantly from increased global diversification because, all else being equal, this would entail greater investment in the US equity market – the most liquid, lowest-cost market in the world.
Tax Considerations
For many investors, the tax treatment of foreign versus domestic assets can vary significantly. Taxes generally fall into four categories: capital gains, dividends from equities, interest from fixed income, and transaction or stamp taxes. The degree to which an investor is exposed to these taxes could help determine whether it would be advantageous or disadvantageous to increase foreign exposure.
Politics and Regulation
Other factors that may occur less frequently may also be important, depending on a country’s locale, including political risk, the domestic regulatory framework and investor protections. These can be difficult to quantify; however, they have the potential to add significant risk to a portfolio that is highly exposed to domestic securities, so it makes sense to incorporate these considerations into the decision process.
However much home bias an investor decides is appropriate, the portfolio construction process should start with choosing an asset allocation strategy based on risk and return expectations. Vanguard believes that global market-cap-weighted index funds are a valuable starting point for all investors, but we acknowledge that the average investor takes on a home country portfolio bias. In deciding how much home bias is appropriate, investors should consider the risk, return and cost implications of taking a more global approach.
Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com
