Portfolio Strategy Commentary: Home Country Bias

Home country bias is a global phenomenon that may happen consciously or unconsciously. While there are many good reasons for home country bias, there are some pitfalls of which to be aware.

We wouldn’t expect the “home team” to be made up of locals. Consider if the Toronto Raptors hadn’t signed L.A.-born Kawhi Leonard, or if Michael Jordan, who was born in Brooklyn, New York, hadn’t played for the Chicago Bulls. While we may be drawn to the local and familiar, there may also be benefits to looking outside of our sphere.

Now consider the world of investments. The preference for the familiar is evident across many developed countries. Pension plans, as one example, regularly hold a higher percentage of their equity assets in home country equities than they would if they held country weights in proportion to major global indices. For example, while Canadian Defined Benefit Plan asset mix appetite for domestic equities has decreased over time, Greenwich Associates reported that Canadian Defined Benefit Plan asset mixes held 18% of their public equities in Canadian stocks in 2020, versus the MSCI ACWI weight for Canadian equities of 2.7% (3.1% of MSCI World). Other examples are displayed in Exhibit 1. This shows a substantial bias toward domestic equities. Retail investors quite often will have a notable home country bias as well. Why is this a concern? Domestic equity markets may possess concentration issues, while international equity markets may act as a diversifier and lower overall risk. Our goal in the following analysis is to determine appropriate ranges for domestic equities within an investors’ equity basket. We focus on the risk side of the risk/return equation as we recognize that “past performance is not a guarantee of future results”, but that volatility tends to mean-revert.

Let us consider a simple comparison – the sector weights of individual country indices versus a global standard, in this case the MSCI All Country World Index (“ACWI”). Such a comparison quickly reveals the manner in which many countries’ equity markets skew toward, and away from, the global standard weights for particular industries. With the exception of the U.S., which has a bigger impact on ACWI given it represents nearly 60% of the broader index, each of the countries in Exhibit 2 show at least one sector which varies over 20% from ACWI weights. For example, South Korea is massively overweight Technology, while Australia is underweight Technology and overweight Financials. And even within the U.S. we see a more than 5% overweight to Technology.

In absolute terms, shown in Exhibit 3, the MSCI USA Index has over 28% allocated to Tech, which introduces a substantial concentration to that sector. Such deviations from global sector weights raise concerns about sector concentrations when investors are heavily invested in home country equities.

Some argue that holding domestic companies still provides global diversification, but multinationals within each country may not provide sufficient diversification from a revenue perspective either. For example, in Canada, 55% of revenue is imported from the U.S. and overseas, but that non-domestic revenue is concentrated in certain sectors such as Materials, Healthcare, and Technology. This leads to concerns of insufficient diversification of revenue sources in other sectors. This experience is not isolated to Canada, as shown in Exhibit 4. Indeed, even for the U.S., the majority of revenue is domestic, and the market would be susceptible to local economic disruptions

If we consider concentration beyond sectors, to individual names based on market capitalization, we see in Exhibit 5 that the top 10 concentration of names in local markets leads to serious diversification concerns. For this analysis we used the MSCI IMI indices as they represent the investable universe for each country. Even in the U.S., the top 10 names make up 23% of the MSCI USA IMI Index. In fact, U.S. concentration has become an increasing issue of late given the stock performance of companies such as Apple, Microsoft and other tech behemoths. In New Zealand, the top 10 names make up an astounding 76% of the MSCI New Zealand IMI index. All of the country indexes that we reviewed had a higher top 10 concentration than the MSCI ACWI IMI Index (14%).

Another important aspect is the way in which country diversification can provide a smoother ride. The volatility benefits of international diversification are clear. When the volatility of local market returns are compared to ACWI (in their respective domestic currencies), ACWI is often lower, as shown in Exhibit 6. The only exceptions in the exhibit are U.K. and U.S. equities versus ACWI (in respective local currency terms). The differences are modest – and history shows periods where both U.K. and U.S. equities can underperform. We show this in Exhibit 7, which presents the rolling 10-year standard deviations of the MSCI USA Index and ACWI (in USD) over a longer period of time. While recently ACWI volatility has been higher, U.S. volatility was higher for a long sustained period between 2000 and 2008. A similar analysis of rolling 10-year volatility for MSCI U.K. versus ACWI (in GBP) shows that British volatility has been higher than ACWI since December 2018.

Currency can also act as a diversifier for equities, which is a positive outcome from a risk perspective. Exhibit 8 shows the standard deviation of hedged vs. unhedged indices from an American, Canadian, Australian and British investor’s perspective. In all examples for the Canadian and Australian investor, the volatility from unhedged foreign returns is lower than that from hedged foreign returns. For a British investor, the impact is effectively neutral for the developed global markets presented. Notably, for an American investor, currency adds to equity return volatility over the observed period.

Finally, we review combinations of local and foreign equities in increments of 10% to see the foreign equity allocation amount that provides the lowest volatility for the equity portfolio. Volatility is always lowest in equity portfolios that at least include some allocation to foreign equities. Notably for South Korea, Canada and Australia, the lowest volatility combinations include just 10%, 20% and 30% domestic equities, respectively.

Let us now consider the global index, ACWI, and the well-known efficient market hypothesis, which stipulates that efficient markets will incorporate all available information into asset prices (liquidity allowing). This leaves us with the notion that the optimal portfolio is the global portfolio; that is, each market held at its ACWI weight. Exhibit 10 shows select countries’ ACWI market weights.

Therefore, if we combine the results from Exhibit 9 with the ACWI country weights in Exhibit 10, we can set some basic guidelines for home country weights within an investor’s equity basket. While the country weights in Exhibit 10 should be treated as a base starting home allocation, Exhibit 9 gives us a maximum domestic weight, by way of considering the related home percentage versus the foreign percentage presented (for example, an 80% allocation to foreign equities to minimize equity volatility for a Canadian investor would lead to a 20% maximum for Canadian equities in their equity bucket). Equities can then be optimized within these ranges using relevant risk and return capital market assumptions for the investor with market weights as a base starting point (as presented in Exhibit 11). Once those target allocations are determined, they can be dialed up or down based on the qualitative considerations that we have outlined above as well as those considerations that we discuss in the following section. It should be noted that investors should have a solid rationale for increasing the weight to their domestic market (over and above market weight), such as strong capital market assumptions, an investment edge in the domestic market, or risk reduction/diversification purposes.

We note that following these guidelines, a U.S. investor’s domestic equity allocation would be anchored at approximately 60% of their equities, but could range as high as 89%, based on current data. We believe that due to sector concentrations, and other issues of concentration and diversification outlined above, that foreign equities should not be entirely eliminated from a U.S investor’s portfolio, as they can still serve as a useful diversification tool. Indeed, our current Strategic Asset Allocation recommendation for U.S. equities is to hold them at the lower-bound base market weight.

In addition to considering the risk items above, we must address qualitative concerns and barriers with respect to international investing. With respect to equities, concerns include the following:

• Cross border investment costs (including taxes)
• Regulatory barriers
• Sovereign risks and quality
• Information asymmetries, including lack of knowledge in foreign markets

For sophisticated investors, where investments tend to be professionally managed, the above concerns are somewhat mitigated. Still, they should be considered on a client-specific basis. Exhibit 12 gives an overview of items which may contribute to a home country allocation decision for any global investor.

Just like sports teams recruit the best players, the goal of investing should be to win by using diverse talent. You may not find what you need at home, and to be competitive you need to look across borders. Diversification is the one “free lunch” in investing. Adding foreign equity investments to a domestic portfolio helps produce more diversified portfolios and alleviates concentration risks related to investing domestically only. The trick is to identify the right balance. Many rational reasons validate a home bias, but we have presented analysis to challenge that bias and a framework for working out allocations to home country equities. This approach can assist investors in finding an appropriate mix.

© 2022 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.

IMPORTANT INFORMATION. For Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. Information is subject to change based on market or other conditions.

Past performance is not indicative of or a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.