"There's no place like home."
The famous quote from "The Wizard of Oz" can be used to describe investors' desire and tendency to concentrate their investments -- especially equities -- in their home countries, and in some cases, closely knit neighbouring countries. Home country bias is a real observable phenomenon that exists not just in Canada but around the world. So why do investors tend to favour domestic equities over foreign equities?
From a practical investment standpoint, home country bias may be justified by reasons such as currency concerns and higher costs associated with investing abroad. For individuals, financial assets are held primarily to meet liabilities such as paying expenses or funding retirement income. The vast majority of these liabilities are in the investor's home country's currency and move with local interest rates, so keeping a portion of assets in local currency helps shield the portfolio from unwanted currency and interest rate movements. Although hedging can be used to mitigate these risks, a well-thought-out hedging strategy can be complex and costly to execute and implement, which leads investors to favour assets that trade and pay in their home country currency.
The cost associated with holding securities (in the form of expense ratio and tax) outside of one's home country can be substantial and act as a deterrent to invest abroad. For Canadian investors, foreign equity products are generally more expensive than domestic equity products. MERs for foreign equity funds on average are about 20 basis points (0.2%) higher than those of Canadian equity funds. This represents a significant hurdle that can make foreign investments that would otherwise be considered attractive perceived as not worth holding. Foreign companies may be subject to double taxation, adding another layer of cost and further discouraging investors from holding foreign investments.
Greater familiarity and easier access to information in domestic markets also plays a role in influencing investors' decision to choose between domestic and foreign equities. Developed markets such as Canada and the U.S. where listed companies are required to report and file important information with the securities commissions on a regular basis facilitates better access to information. Equivalent information can be more difficult to obtain in less developed markets such as emerging and frontier markets.
Quirks in human behaviour and reasoning influence how investors select their investments, often without their conscious knowledge. Affect heuristic, a term used by Nobel laureate Daniel Kahneman, refers to how one's assessment is being guided by feelings of like and dislike with scant rational reasoning. Affect heuristic is particularly relevant in understanding home country bias since we tend to have positive feelings toward countries and companies that we know about and are generally less comfortable with holding investments that are unfamiliar or foreign to us. Even the most experienced investor is susceptible to this innate behaviour.
Most investment products that are manufactured in Canada have a built-in home country bias. For those who invest in a pre-built multi-asset class investment fund there is a good chance that there will be a significant portion of the assets invested in Canada. Looking at the holdings of 182 funds in the Global Neutral Balanced category, the average breakdown is 19.1% Canadian equities, 17.6% U.S. equities and 13.9% International equities, with the rest in (mostly Canadian) bonds and cash. This represents a significant overweight in domestic equity, considering that Canada's stock market accounts for only 4% of the world's equity market capitalization (as determined by the MSCI All Country World Index).
Canadian investors who chose to keep their equity investments at home over the last decade were nicely rewarded. Strong global growth, particularly in China, drove commodity prices and the Canadian dollar up due to an insatiable appetite for raw energy and commodities. The S&P/TSX Composite Index returned 8.8% on average for the past 10 years ending April 30, 2014, making Canada one of the top performers and outpacing many foreign markets including the United States, where the S&P 500 Index was up only 5.3% (when converted in Canadian dollars). But while the long-term numbers look good for Canadian equities, over the past 12 months the domestic market has lagged the U.S. and global markets as expectations for a sluggish global growth pushed commodity prices lower and took Canadian stocks along.
A portfolio with a high proportion of Canadian equities could bring significant volatility. Our market is highly concentrated in three sectors: financial services, energy and materials stocks combined make up over 70% of the market index. During the global financial crisis, investors with a strong bias to Canadian equities suffered due to a lack of diversification. From May 2008 to February 2009, the S&P/TSX Composite fell by more than 43% whereas a more diversified index such as the S&P 500 was down 32%. Diversification outside of Canada expands the investment universe to sectors that are under-represented in our market such as health care, information technology and the consumer sectors.
When building a well-diversified portfolio, it is important to recognize our natural biases and work to minimize the negative impact of home country bias. Even though investing domestically has worked well for Canadian investors in the past, especially during commodity booms, holding foreign investments is beneficial from a risk management and diversification perspective over the long term.
