Global and Proud
Home bias refers to the tendency for investors to cluster their holdings in domestic markets.
This has been well documented in the literature and although not fully understood, the reasons for this behaviour are believed to be explained through a combination of rational and behavioural factors (Ardalan 2019). By concentrating their investments in one country, investors not only miss out on the opportunity to invest in faster growing economies, they are also more vulnerable to volatility in that market. Therefore, in line with our views on the importance of international diversification and supported by the findings of Driessen and Laeven (2007) and Scott, Balsamo, et al. (2017), Betafolio takes a global approach to asset allocation.
As to the actual allocation of capital to each market, again, we allow theory to provide a guide. Betafolio subscribes to Fama’s (1970) Efficient Market Hypothesis, whereby, over the long run, markets are broadly efficient and global capital will migrate to destinations that offer the most attractive risk adjusted expected return. In essence, we believe money will flow to the regions that offer the most favourable returns, and as such, we replicate the market’s allocation.
The surprise result of the June 2016 European Union referendum provides a recent UK centric example of the impact that a home bias can have on investment returns. Immediately following the result, predictably, UK equity markets fell sharply, given the uncertainty associated with the ramifications of leaving the EU. Although the UK equity market rebounded almost as quickly as it had fallen, the prolonged political rigmarole that followed served to subdue performance for a number of years compared to the global equity market. Over the 3-year period immediately following the vote, UK equity returned 31.96%, while the rest of the world returned 60.74%.
Another recent example of the additional risk of maintaining a home bias can be illustrated from the prospective of a South African investor. Despite avoiding recession in 2019, the stock market was held back by weak economic growth, low commodity prices and continuing political wrangling; preventing any real progress in addressing the wider macroeconomic and social challenges that continue to hinder the country. During 2019 the South African equity market returned 5.79% while the global equity market returned 22%.
The preceding examples are of course based upon a short time horizon. In the long term, performance and volatility will revert to their long-term average due to the phenomenon of mean reversion. Consequently, an investor with a home bias will not see a significant change in their long run efficient frontier. However, the measure of risk, that of volatility used in the construction of the efficient frontier does not consider idiosyncratic risks, particularly geopolitical risks. As such maintaining a home bias exposes an investor to risk, for which they will not be compensated.
Proponents of a UK home bias also argue such a strategy is essential to protect against UK inflation. However, the data does not support such a proposition. While UK inflation increased by 31.33% over the period 2010-2020 global equity returns were 147.30%.
Betafolio’s core philosophy is to utilise the vast quantity of theoretical and empirical research together with our own inhouse analysis to make objective and informed investment decisions. Although a home bias is common and somewhat understandable from a behavioural perspective; we all prefer the knowns to the unknowns, the evidence does not support an increase in risk adjusted return by pursing such a strategy. As such, we take a global perspective to investing and therefore hold investments in each market in line with their market capitalization.
Ardalan, Kavous. 2019. Equity Home Bias in International Finance: A Place-Attachment Perspective. London: Routledge; 1 edition.
Driessen, Joost, and Luc Laeven. 2007. “International Portfolio Diversification Benefits: Cross-Country Evidence from a Local Perspective.” Journal of Banking & Finance 1693-1712.
Fama, Eugene. 1970. “Efficient Capital Markets: A Review of the Theory and Empirical Work.” Journal of Finance 383-417.
Scott, Brian J, James Balsamo, Kelly N McShane, and Christos Tasopoulos. 2017. “The Global Case for Strategic Asset Allocation and an Examination on Home Bias.” Vanguard Group. January. https://www.vanguard.co.uk/documents/adv/literature/strategic-asset-allocation.pdf.