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By Christine Benz | 09-03-2013 12:00 PM

Malkiel: Be Careful of the Home-Country Bias

Investors are making mistakes by focusing on domestic-oriented names and not having enough foreign exposure, especially with emerging markets, says author and Princeton professor Burton Malkiel.

Christine Benz: I know that you think most investors would probably be better off buying an all-index portfolio and calling it a day. But are there any sectors or categories where you think one might reasonably investigate some sort of actively managed product? Small caps are sometimes held out there as a sector where you might use an active manager, or perhaps international. Are there any areas that seem somewhat more reasonable to you than others?

Burton Malkiel: I still tend to be a skeptic about the sectors of the market that supposedly are going to do better. And small cap does do better than large cap over certain periods, and certainly over history in the United States has done better [during certain periods]. Value has done a little better than growth over long periods of time.

Usually when people think of Fama-French framework, they do think that size and value are important. Now a lot of people use a Carhart four-factor model and include momentum in it. There's even a momentum ETF. So, if you believed in that, you would then go to the Momentum ETF. It has not outperformed the broad market ETFs. It's not outperformed its benchmark.

There's some empirical evidence that there are parts of the market that give you somewhat higher long-run rates of return. And I'm not dismissing that, but I guess what I'm saying is I'd be somewhat careful not to go overboard on that.

Where I do think people are making a mistake is in what might be called the home-country bias. The United States is only about one third of the world's GDP, and the developed economies of the world are now only about half of the world's GDP. And the developing economies not only account for about half of the world's GDP, but they're also growing faster. And while the growth rates are coming down, everyone is throwing up their hands [saying,] "The growth rate is coming down in China. India is having problems, and Brazil is having problems." There is enormous pessimism about these markets.

Going back to my view that you want to be as broad as possible, I don't think people have enough of their portfolios in foreign markets in general, and emerging markets in particular.

If I were going to do something, I think that would be the case, and I do think the relative valuations with the pessimism in emerging markets are just enormous. Emerging markets used to sell at valuation metrics like price/earnings multiples 20% above developed markets, and now they're 20% below these markets.

Now, I want to be very careful about making the asset-allocation decisions. But when I put that together with the home-country bias and look at portfolios in the United States, both individual and institutional that tend to be very underweighted [in foreign exposure], I wonder whether that's not an area that we should be thinking about more carefully.

Benz: It seems like one argument that people sometimes make for not equal-weighting countries is that you do get significant foreign currency fluctuations which add to your risk/reward profile if you are fully invested according to market cap in foreign markets. What do you say to that argument?

Malkiel: I think that, in general, I would worry less about that. If you have a country whose currency is falling, it's normally associated with higher inflation. And therefore, the nominal value of your holdings should rise to offset some of that.

Again, I would say that there is probably some offset from investment in countries where the currency is falling. But I think I'd also say that in many cases, the currencies might very well go the other way. I think, for example, that on a purchasing-power basis, China has an undervalued currency. I don't know that I'd want to hedge that out. I'd be very happy to take my chances, and I think they might even more likely go in my favor than against me. I am not as worried about that argument as many other people are.

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