The authors note: “The rationale for diversification is clear—domestic equities tend to be more exposed to the narrower economic and market forces of their home market while stocks outside an investor’s home market tend to offer exposure to a wider array of economic and market forces.” Yet in a 2017 study, Vanguard found that in each case they examined, investors exhibited a strong home country bias.
When they examined returns over the period beginning in 1970, Scott, Stockton and Donaldson found that, “While the United States had the lowest volatility of any individual country examined, its volatility was slightly higher than that of the global market index.” When they performed a forward-looking 10-year minimum variance analysis, they found that in each market, the marginal benefit to international diversification declines as allocations to international equities increase, with portfolio volatility beginning to rise with allocations of greater than 40-50% to international equities.
The authors also examined the issue of currency risk. They first note: “Long term, currency has no intrinsic return—there is no yield, no coupon, no earnings growth. Therefore, long term, currency exposure affects only return volatility.” In terms of volatility, they found that, in all regions, currency risk had very little impact on long-term performance, whether or not it was hedged. Sometimes hedging reduced volatility; in others, it led to an increase.
Scott, Stockton and Donaldson concluded that a good starting point for investors is the global market-capitalization weight.
An interesting question is, are sophisticated professional money managers as subject to home country bias as individual investors?
How Professionals Handle It
To answer that question, Moritz Maier and Hendrik Scholz, authors of the January 2019 study “Determinants of Home Bias: Evidence from European Equity Funds,” examined the holdings of 699 actively managed equity funds, domiciled in 15 European countries, that broadly invested in European stocks over the period January 2003 to December 2016.
Following is a summary of their findings:
- More than 90% of funds show, on average, a home bias.
- The home bias was present in all 15 markets. France had the highest overweighting (30%), followed by the U.K. (24%) and Germany (21%).
- On average, funds overweight their domestic stocks by about 16%. At the 90th percentile, the overweight was about 36%.
- The home bias across funds is quite stable over time.
- The home bias of individual funds is, on average, positively related to the relative size of the stock market, the cumulative 12-month lagged domestic stock market return in excess of the European stock market return, real GNP growth and the country’s credit rating.
- Informational advantages do not seem to be a reason for the observed home bias.
- The differences between future returns of the stocks bought and sold by funds are essentially zero.
The bottom line is that there is strong evidence that sophisticated professional money managers exhibit the same behavioral home country bias (such as confusing familiarity with safety) as individual investors, though to a lesser degree. Since they don’t achieve higher risk-adjusted returns on their home country holdings, they are sacrificing diversification benefits without any offsetting gain.
As Vanguard recommended, a good starting point for deciding how much to allocate to international markets is the global market capitalization. That said, there are some valid reasons for a U.S. investor to have a small home country bias.
When investing internationally, implementation costs can be higher in terms of expense ratios of funds, trading costs and taxes. Thus, while the global market capitalization is a good starting point for allocating capital, the higher costs of investing internationally might lead to a slightly higher allocation to U.S. stocks. On the other hand, if you are still employed, your labor capital is likely to be more exposed to the idiosyncratic risks of the U.S. economy. Thus, if your labor capital is highly correlated to the U.S. economy, you might consider an even higher allocation to international stocks.
Larry Swedroe is the director of research for The BAM Alliance.
This commentary originally appeared April 3, 2019 on EFT.com.
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