Thu, 18 Oct 2012
U.S. investors are much more globally diversified than many investors abroad, but when it comes to fixed income, it pays to stay home, says Vanguard's Chris Philips.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. Most investors throughout the world are biased toward their home markets. I recently sat down with Chris Philips who is a senior analyst in Vanguard's Investment Strategy Group to discuss some recent research on home-market bias.
Chris, thank you for being here.
Chris Philips: My pleasure.
Benz: You and the team here recently conducted some great research into home-market bias, the extent to which someone in, say, the U.S. has perhaps a disproportionate share of his or her portfolio in U.S. stocks. And you examined this issue, but let's start with home-country bias and what you found when you examined four markets. You looked at the extent to which investors in these four global markets were perhaps disproportionately exposed to their home country. You looked at the U.S., Canada, Australia, and the U.K. What did you find market-by-market?
Philips: So actually we went into this asking two questions. One, how much home bias is there? And two, whether it's rational or not to actually have it? So, what we found was that not surprisingly, the U.S. is at the lower end of home-country bias. Now, we're the largest country out there, so simple math would tell you that the more international stocks we hold, the ratio is just going to be much more in our favor.
What we found that was really interesting was, when you start looking at Australian investors, Canadian investors, U.K. investors, they have a disproportionate amount of holdings in their home country. Despite the fact that Australia might be 3% of the global marketplace, investors there have upwards of 70% exposure to Australian stocks. So we really wanted to dig into that, figure out why that is and whether it's irrational for these investors across all these domiciles to actually have that exposure.
Benz: So, backing up to the U.S. question, what you're saying is, the U.S. is a bigger portion of the global market. So, without even trying to go out and get global exposure, we automatically just have a bigger share of the global market?
Philips: Yes. If you start with 100% of your stocks in U.S. companies and you just move to 20% of that in foreign stocks, that's a significant portion of your portfolio. But because the U.S. is already such a large slice, it's not like we were 1% of the globe and we moved from 100% in the U.S. to 20% [foreign] where we're still significantly overweight. It's just the U.S. is very unique in the global marketplace, but that doesn't mean that investors shouldn't be aware of home-country bias and what impact that can have on a portfolio.
Benz: So, within the paper, you looked at various factors that might cause one to rationally overweight a home market or might in fact argue in favor of backing away from that home-country bias. You talked about the composition in terms of sector exposure of your home market. So, some markets might be very concentrated in a handful of sectors; what would that argue for?
Philips: So, here we're actually looking at if the theory would tell us that we would start with a globally market-proportioned portfolio, that if I am a U.S. investor, theoretically you would want to have 45% in the U.S. and 55% in non-U.S. stocks. That's kind of what the globe constitution is today. Then you start deviating from that, and a lot of it depends on these various factors.
So, to your point on the sector concentrations, we started with the globe and said, "What are the sector weights, whether it's energy or materials or health care or tech stocks out there? And how different does someone who is just in the U.S. look relative to the globe versus someone in say Canada? How different would they look from the globe?"
And what we found was is that, again, not surprisingly, the U.S. has the closest approximations to the world sector allocation, whereas Canada is very concentrated in three sectors, to the point where those three sectors, I believe, account for over 60% of the total portfolio and then the remaining seven sectors of the 10 total account for the rest.
So, if you're just in Canada, you have very, very heavy allocations to resource and energy stocks, and then in some areas--and this may come as a surprise to some people--Australia actually has a very heavy allocation to finance its stocks and much more so than the global portfolio. So, you can become very concentrated in these sectors which bears its own risks.
So, when we're thinking about what the implications are, one could look at that and say, "Well, that's actually a pretty significant risk exposure; maybe if I'm diversifying away from my home country, then I'm actually diversifying my exposure across all these sectors so finance isn't playing such a huge role in my portfolio or energy isn't playing such a huge role in my portfolio, again relative to the global market cap."
Benz: The takeaway would be then if I lived in a country that was heavily concentrated, its economy was heavily concentrated in a few sectors and its market was as well, then I would have a better case for globalizing my portfolio?
Benz: And you also noted that certain markets are very concentrated in maybe just a handful of companies where they represent a large share of the value of that country's market?
Philips: Absolutely. And it was interesting to us because we hear a lot about investors who are nervous or fearful of investing in even, say, the S&P 500 because that's concentrated in the largest names, such as Apple, GE, kind of your big names. Apple makes up 3% to 4% of the U.S. market, but if you look at some of these foreign stocks or foreign countries, you could have individual securities that account for 10%, 15%, 20% of that benchmark index. Some countries we didn't cover would be something like Switzerland where Nestle could account for over 50% of the domestic index. So that's a very significant and very concentrated portfolio that if I am investing just in my home country and the top 10 holdings or top five holdings account for 50%, 60%, 70 % of all the market cap, all else equal, diversifying away from it from it, by adding in foreign securities, you are lessening the impact of those big companies on your overall portfolio.
Benz: One interesting thing in the paper I thought was the assertion that country of domicile actually does matter. I know some people have said, well, you know it's a big global world and a lot of U.S companies actually have extensive foreign operations, so maybe they are pretty global and not all that correlated to the U.S. market. You found country of domicile though actually does matter in terms of how the stocks perform.
Philips: Absolutely. And the way I think about it intuitively is [look at] Apple. Apple has operations overseas, manufacturing plants, and sales branches overseas. The revenue streams in Apple's eyes would want to be as smooth as possible. So, it's in their business interests to try and eliminate a lot of the currency or foreign exchange exposures they have in their manufacturing process, in their global operations. So they are going to be active players in the currency markets to try and eliminate a lot of these risks.
But when you actually invest in a company like Siemens who's domiciled in Germany, you're getting that influence in your portfolio along with any other influences they have, whereas just focusing on those multinational firms that are domiciled in the U.S., you are not necessarily getting a lot of the exposures that you could be getting by having Nissan or Siemens or Nestle or some of these other big firms that are domiciled elsewhere.
Benz: Last question for you, Chris. Fixed income is an area where investors typically have a strong home-country bias and stick largely with bonds issued by corporations or governments in their home country. You think that there is actually a rational foundation for that. Let's discuss that.
Philips: Sure. It's most prevalent on the institutional side where they actually have explicit liabilities or other influences that would say that having U.S. Treasuries, U.S. corporate bonds makes all the sense in the world. You can also have institutional investors who have investment policy statements that say that they cannot invest in foreign fixed income for whatever reason. But even for individual investors, when I think about my future liabilities--whether it's for my son as he is going to a college in the future, college inflation, health care, inflation--these are all U.S.-specific objectives and liabilities that having that exposure to U.S. fixed income, U.S. assets, can be very beneficial to meet those long-term liabilities or the future expenditures that we expect to make.
When you actually look at foreign fixed income from a U.S. perspective, there can be a tremendous amount of volatility there, and what we would not want to do is have the portfolio in the effort to diversify actually take us away from some of the objectives that we have already baked in. So, in the fixed-income sense, we actually do believe that there is a fairly strong case to have a home bias, and we see that globally, as well.
Benz: Well, Chris, thank you; very valuable research. Thanks for sharing it with us.
Philips: Oh my pleasure. Thanks for reading it.