Is there no place like home?
by Charles Cheng, CFA
We have just passed the ten-year anniversary of Lehman Brother’s collapse. While the crisis is a reminder that in investing, one always has to be prepared to weather the toughest times, the long equity bull market that followed is testament to the value of staying invested in spite of uncertainty. This typically involves deciding on risk level and asset mix that is suitable for oneself as an investor, but there is still the question of which countries to allocate to. Here, we take a closer look that topic: home country bias versus international diversification.
It’s well documented that investors overwhelmingly prefer to invest in their home country’s securities markets. Some of this preference is due to practical reasons such as having the same local currency, access to more local investing products, and daytime trading hours. Some is due to more subjective factors, such as having a higher comfort level and more familiarity with the local companies, politics and economics. To be sure, allocating a portion of your portfolio to local companies which you have confidence in for the long term, and which have sustainable competitive advantages that you can identify, can be a sensible investment decision. But is it reasonable for most people to massively overweight their portfolio in local securities?
Source: JP Morgan Guide to the Markets 3Q 2014
We separate this problem into two questions. First, is it easy for investors to outperform their home market indices on their own? Not likely. There is a mountain of research that suggests that institutional investors very rarely can sustain outperformance of market indices, especially after fund fees. A 2017 Standard and Poors SPIVA study on fund performance showed that 95% of professional Large Cap managers underperformed the S&P 500 over the trailing 15-year period. The same study done in Australia showed 77% of Australian managers underperformed their benchmark. Furthermore, evidence shows that retail investors tend to get timing wrong, over-allocating to equity funds at market peaks, and under-allocating at market bottoms.
Source: JP Morgan Guide to the Markets 3Q 2018
The second question is if even if they can’t consistently outperform their home market index, do they benefit from being biased toward their home country? In hindsight, of course that depends on which country that is. US based investors would have benefitted from the outperformance of their country’s indices in recent times while European investors would have suffered underperformance. Clearly, there will be winners and losers in this kind of behavior, as not every country can outperform at the same time. Over the past ten years since the Lehman collapse and recovery, emerging market countries have underperformed the global market on an absolute basis and especially on a risk-adjusted basis.
For a long-term investor, if it doesn’t make sense to have your starting point be your home market index then what should it be? Some would base their allocation decisions on historical performance or on which countries they believe have the best long-term economic outlook. We would argue that a good starting point would be the global market capitalization weighted portfolio.
Just because a company is listed in a country doesn’t mean that its business is all or even partially there. Around 30% of the revenues of companies in the US S&P 500 Index are from non-US countries. Also, many countries listed in Asia are export driven, which means that the ultimate consumer is largely in the US. And there are world class companies all over the globe.
Source: Credit Suisse Global Yearbook 2018
To be fair, capitalization weighted indices may not be the most efficient way to access these returns, although they may be among the cheapest. However, it can function as a good starting point to anchor your portfolio bets and tilts and can also diversify your individual country risk. Many investors are also doubling down their already high risk exposure to their local economy that they have through their job or business by investing locally.
Source: Credit Suisse Global Yearbook 2018
According to researchers at Princeton University, the global market portfolio has returned 5.2% after inflation for equities and 2.0% after inflation for bonds since 1900. In nominal terms for equities, that’s greater a doubling of the investment value every ten years for the past 118 years. That’s an excellent long term return without having to go through the trouble of trying to pick winners or losers.
Mr. Cheng is a managing partner at Clarity Investment Partners, a Hong Kong based independent private investment office.