Home bias may have merit

The propensity to invest in one’s home country is a well-documented characteristic of inventors. Around the world investors show a preference to invest close to home, virtually ignoring foreign opportunities and proven benefits of sectoral and geographic diversification of portfolio.

The phenomenon, known popularly as “home bias” also exists in Canada, the equity markets of which comprise a measly four percent of the global equity market. What limits this market even further is the fact that it is heavily tilted toward the financial and resource sectors, and very little else.

Canadian portfolio pundits acknowledge the existence of home bias and its limiting effects. Many, however, firmly support it and offer a variety of explanations for the soundness of the practice in the Canadian context.

Aimé Bwakira, director of investment analysis at Fidelity Investments Canada, borrows a quote from Andrew Carnegie to justify such behaviour: The wise man puts all his eggs in one basket and watches the basket.

“A certain amount of home bias has served Canadian investors well in recent years as Canada has benefited from multiple favourable tailwinds,” says Bwakira. “Canada’s resiliency during the global financial crisis and economic recession relative to other developed countries meant that it outperformed both the S&P 500 and the MSCI EAFE between 1990 and August 2010.”

A compelling argument it may be, but one that Greg Nott, portfolio manager with Russell Investments Canada is not buying into. Whether he’s looking at stocks or fixed income, he’s resolutely opposed to investors’ preference for geographically proximate investments.

“Canadian investors who have all of their fixed income allocation within Canada are missing out on some of the best return enhancement opportunities in the fixed income marketplace,” says Nott. “Similar to equities, the Canadian fixed income market makes up a very small percentage of global fixed income markets. Therefore, looking beyond just the domestic market can have added benefits.”

Given the current low yields, it is more important than ever that investors seek to maximize their return for a given level of risk, he says.

Taking the capital across political and monetary boundaries is one way to achieve that goal, says Marc-Andre Robitaille who manages AGF Dividend Income Fund.

“Eighty percent of our equity market is represented by resources and financials (which) causes a problem in my opinion to be so concentrated and not benefit then from the risk-reward of a better diversification,” says Robitaille, explaining that international diversification provides additional benefits. “If you think you’ll retire here and spend your money here in the future, you should have a good proportion of your portfolio here in Canada, but there is still diversification benefit that will improve the risk-return characteristics of a portfolio having some investment outside of the country.”

Robitaille asserts that healthcare and technology, for instance, represent huge sectors in the rest of the world, but are relatively small in the domestic market. Portfolio managers who wish to be invested in these sectors are better off looking beyond Canada.

Detractors of overseas investment, however, are quick to point out strong headwinds created by currency fluctuations that could affect investments outside of Canada. Bwakira points to how the stronger loonie contributed to the Canadian market outperforming others. “A stronger Canadian dollar has reduced the performance of unhedged foreign investments,” he says. “The Canadian dollar appreciated by 45% against the greenback from end of July 2000 to end of July 2010, growing from about 67 cents to near parity.”

The same goes for the euro. The Canadian dollar, although quite volatile against the euro over the past 10 years, has rebounded from a low of 58 euro-cents at the end of December 2008 to 74 euro-cents at the end of August 2010, argues Bwakira.

Nott, a proponent of foreign fixed income allocation, dismisses that argument and suggests neutralizing the currency risk as an antidote. “We would recommend that the vast majority (at least 90%) of the non-domestic fixed income exposure be currency hedged back to the Canadian dollar.”

He admits, though, that currencies can be very volatile and could swamp any excess return generated from opportunities outside of Canada.

Other home bias explanations focus on increased global demand for Canadian commodities, the perennial favourite of Canada’s financial landscape.

“Canada has benefited from a rebound in resource prices,” says Bwakira. He presses the point with the example of oil prices, which traded for $10 a barrel in 1999, then subsequently shot up through the following decade. “Gold, fertilizers, almost every commodity has profited from increased demand and the rapid growth in emerging markets.”

Stephen Lingard, co-lead manager of Franklin Templeton’s Quotential program, uses Canada’s strong economic foundation as the primary factor for discouraging investment abroad. “Canadian equities have one of the better opportunities to perform on a forward basis, looking at the economy within the next five or 10 years.

“A home bias, from the point of view of the Canadian investor, will serve investors reasonably well.”

Of course, he limits this comparison to G8 economies – the U.S., Western Europe, and the UK. Lingard is not averse to taking advantage of opportunities in foreign markets – more specifically, emerging markets.

“People in the industry don’t have very much allocation to emerging markets, both from an equity market and a fixed income market perspective,” says Lingard. “And that’s a real travesty (because) these are some areas that have offered very good economic growth potential.”

Too much of a home country bias, he concedes, can constrain investors’ overall risk and return opportunity. Additionally, Canada’s economic strength becomes a weakness if a country is regarded as stock, as Robitaille does. “I’m not saying Canada is overpriced, but [Canada’s superior economic performance] comes for a price.”

He points to a key aspect largely overlooked in the debate. Markets that performed poorly could well be the next growth leaders. “By only being invested in Canada, investors might miss out on opportunities in countries that didn’t do that well in the past couple of years, but are on the verge of a rebound and are now undervalued,” says Robitaille.