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Diversification means investing overseas too

Ben Johnson, CFA  |  14 Jun 2019Text size  Decrease  Increase  |  
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If diversification is the only free lunch in investing, investors around the world might be leaving a lot on the lunch table.

Diversification is measured across a number of dimensions: individual stocks, industries, sectors, and so on. Most investors' portfolios are fairly well spread along these lines. However, when it comes to investing overseas, many decide to ditch diversification at the border.

"Home bias" is the term used to describe investors' tendency to tilt their portfolios in favour of stocks listed on their domestic stock market (bonds, too, but I'm going to focus on stocks).

A baseline for bias

There are a number of measures of home bias that have been identified by academics through the years. But, for the sake of simplicity, I believe it's easiest to measure your home bias by comparing your current allocation to international equities with the portion of the market capitalisation of global stock markets made up of stocks domiciled outside of the United States.

U.S. stocks, for example, make up around 55 per cent of the world’s public equity market cap. So any U.S. investor’s portfolio that has more than 55 per cent of assets in the U.S. is showing a home bias.

This chart shows the magnitude of home bias among investors in the U.S., United Kingdom, and Australia and how it has diminished (somewhat) over the years.

home bias

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There are a number of reasons investors might be overweighting in domestic stocks. Some are tangible such as concerns about corporate governance or political risk in other countries, additional costs that may be incurred in buying international equities, and currency risk.

Others might argue that the multi-national nature of many companies means that even sticking solely to your home market brings an element of diversification – around three-quarters of FTSE 100 company earnings, for example, come from outside the UK.

Why do we have bias?

There are also intangible, behaviour-related reasons that home bias might manifest such as familiarity, whereby investors feel they know and understand companies which are based in their local market better than those elsewhere.

There are plenty of legitimate reasons why investors might favour their domestic equity market. But I would argue that some of these have grown flimsier with time and they don't warrant the degree of home bias that exists in many investors' portfolios today.

Among the concrete explanations behind home bias, those relating to investment and informational costs and currency risks have arguably become less convincing with time and will likely weaken further in the future. The world is increasingly flat, and barriers to the movement of information and capital continue to come down. The cost of investing in overseas markets has declined with time, and new markets will continue to open to new investors.

One of the most telling examples of this trend is Vanguard Emerging Markets Stock Index VEIEX. It was the first emerging markets index fund when its investor share class launched in May 1994. At the time, the fund's fee was 0.6 per cent, and it tracked the MSCI Select Emerging Markets Index, a narrow representation of emerging markets stocks that was designed for investability as opposed to representativeness.

Fast forward to 2019, and the fund has sprouted new share classes, including an exchange-traded fund share class (Vanguard FTSE Emerging Markets ETF VWO); the fund's fee (for the Admiral and ETF share classes) is a fifth of what it was; and it now tracks the FTSE Emerging Markets All Cap China A Inclusion Index, which includes China A-shares, a market that has only recently opened to foreign investors. Costs have and will continue to come down, as will barriers to the flow of information and capital. These are no longer good excuses to favour domestic stocks.

Arguments are outdated

Avoiding currency risk is another justification that no longer holds water. In recent years, we have seen a variety of ETFs offering exposure to various foreign stock markets that manage currency risk on investors' behalf. Some hedge this risk outright, others hedge away a portion of the risk, and the newest additions manage it dynamically. The growth in the number and variety of these convenient and cost-effective tools that allow investors to take currency risk out of the equation mean that currency risk is no longer a good excuse for home bias.

Ultimately, making the case for greater exposure to international stocks is somewhat easier and more compelling than knocking down the pillars of home bias. It boils down to this:

1) U.S. stocks and foreign stocks have not and will not ever move in perfect unison

2) Pairing assets that zig and zag at different times in response to different fundamental drivers (changes in rates, inflation, differences in fiscal and monetary policies, and so on) is generally a good way to reduce portfolio risk and thus (in theory) boost your odds of sticking to your plan.

3) Perhaps most fundamentally, there will be times when valuations across global markets are out of sync. It is at these moments when taking profits from your winners and adding them to your laggers can make the most meaningful contributions to your long-term returns.

is director of global exchange-traded fund research for Morningstar.

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