Faceoff: Home bias

By Vikram Barhat | November 1, 2010 | Last updated on November 1, 2010
7 min read

Home bias in the Canadian context: Moderated by Vikram Barhat

Is it a good thing?

Som Seif: If you define home bias as being 100% of a portfolio in Canada, then I think it’s a mistake. If you define home bias as being anything that’s over 3% to 4% of a portfolio, then I think it’s very important that Canadians have a home bias.

I think your equity portfolio should be diversified globally with exposure to Canadian stocks, but also global stocks like emerging markets and Canadian bonds. There’s no benefit of investing into bonds — corporate or government — of foreign interests, unless you’re really investing from a currency perspective. When you buy global bonds, you’re really buying currency, not just bonds.

Greg Newman: I think it really can be a good thing. Currently, having a home bias isn’t just good for Canadian companies and the country as a whole, it’s also very rewarding to investors at this time. The emerging world continues to grow, [and] it’s been said by the World Bank recently that by 2015, the GDPs of the developed countries will be overtaken by the developing countries. So there’s definitely going to be a continuing thirst for natural resources, which is in many ways part of the backbone of the TSX.

But aren’t investors who show a strong home bias actually missing out on a lot?

Seif: It comes down to diversification and growth potential in a portfolio. [There’s] a lack of diversification in the Canadian marketplace, given the equities available to Canadians are limited to only a few industries, and a specific quality of companies.

We lack a lot of great technology companies, we lack a great number of healthcare businesses and we lack diversification in our financial services businesses. So we have a lot of good companies, but globally, there are so many great companies out there that you don’t get exposure to if you just invest in Canada.

Then there’s the diversification via the industries and exposures to economic growth; the reality of the Canadian market versus the U.S. market versus the opportunities in Europe or Asia or in other markets.

The reality is Canadian investors need to be thinking about where the growth is coming from economically, and that comes down to countries like Brazil, China and India, [which] are really seeing economic development. Some amazing companies are growing out of those areas. You just don’t have those exposures if you’re going to be investing exclusively in Canada.

Newman: Unquestionably. If you stay within your own borders, you’re going to miss out on some of the other opportunities that exist globally. The tech sector, for example, has some excellent opportunities. [Except for] Research in Motion [and] a couple of other small companies, you really have to go outside the TSX for that.

Is investing in home companies that you know and have easy access to necessarily smart investing?

Seif: Absolutely. I think it’s important to invest in companies, businesses and markets you understand. But I think investing in mutual funds or ETFs in global markets is very important, where the benefit of diversification can come not only from buying into individual companies, but also from access to the economies and broader businesses they can provide. Minimize your risks through investing in diversified portfolios like ETFs or mutual funds.

Newman: Sometimes smart investing is investing in what you know, and being rather simple. An investor like Warren Buffett always says he really has to understand the business he’s investing in.

So if you live in Timmins and you know the people who work the mines there, you can have a pretty good sense of production and costs, and whether management is executing effectively. So I think it can be beneficial.

Can being concentrated in Canadian financials and resources be a big mistake?

Seif: I think it’s very important, because it’s a point of diversification. The reality is, people think everything’s going to be safe until the worst-case scenario hits.

But diversification protects you from the worst-case scenario. We saw that in Nortel. In that case, it was 30% over the index in 2000 and investors who bought it thought it was a safe investment because it was only going up. But over the next ten years it went down; it went to zero. Investors lost a lot of money.

Ultimately, as an investor, those are great case studies to show that you need to think about diversification. It’s really a way to protect against that risk.

Newman: It can, and there are certainly historical episodes where the TSX for many years underperformed the American and global markets. That was, I believe, in the 1980s and the 1990s, when you had the underperformance of gold, you had oil that continued to fall from the highs of the early 1980s.

You had commodity prices, which were very limp, and the real action in the markets, in terms of growth, was in areas like pharmaceuticals, banking and technology. Canadian banks weren’t the most innovative at the time, or they weren’t viewed as such. At that time, it was painful for an investor to have a strictly home bias. So it all depends on which time you’re investing in.

What are the main risks associated with looking beyond Canadian borders?

Seif: Number one is the currency risk. As Canadians, we understand that currency is moving all over the place, and we’ve had very volatile movements in the last five years. You have to be very aware of currency. If you understand the currencies you’re buying into, then that’s good. If you don’t, use a currency hedge.

Secondly, in certain economies, you have to worry about political risks. For example, if you’re invested in China, you have to worry about how the Chinese government is going to look at the yuan or the government rates.

Another thing people have to be thinking about is the risk of taxes. When you buy foreign investments, many times you have withholding tax on dividends, and you lose a lot of the tax efficiency of income. So you have to think about those things when you’re buying global stocks.

Those are all things that you can manage around; there are investment strategies to eliminate some of those risk issues.

Newman: The main risk with looking beyond Canadian borders would be one of currency. There was a time in the 1990s when the Canadian dollar was incredibly weak and everybody thought it was a certainty that it could continue as such. And so many investors fled from the TSX and bought American with both hands, or globally. Some ended up paying as high as 1.6 times U.S. dollars to buy an American company. Another risk would be capital market integrity. There are certain markets globally where you don’t have that same level of assurance [as in Canada and the U.S.].

How does the global economic climate dictate home bias? And should it?

Seif: The global economic environment does make an impact, because if Canada is moving faster than any other market, people will say, ‘Why do I want to bother?’

But the reality is that’s exactly why you do want to bother, because this is a time when the Canadian dollar is valued very nicely. We have a very strong dollar with which to go out and buy foreign assets. Our economy has done very well and the sustainability of that growth is going to be dependent on the other economies.

If the Canadian economy is growing and stocks have done very well, then sometimes you can take your gains and re-diversify into other markets.

It’s just down to the concept of diversification. You can put all your eggs in one basket, and that can work out for you, but all parties come to an end and you need to recognize diversification eliminates the risk of the music stopping while you’re standing still.

Newman: Some investors are opportunistic and their highest aspiration is to get the greatest return. Other investors are very socially conscious and would rather forgo some upside to invest in the socially conscious areas.

And then there are some other investors who are really patriotic, who want to invest that way and are prepared to live with the consequences. Canada is only 2% or 3% of the world’s market cap, so over the long term there’s more risk, and probably some lost opportunity with just staying strictly within our borders.

But there’s always going to be opportunities in Canadian stocks. Canada is a resource-based country, so if the economic climate is such that resources are in high demand, that’s going to be good for Canada. And aside from resources, the other big component of the TSX is the financials.

Right now we’re in the situation where globally, many of the Western economy’s banks have been badly impaired. In contrast, the Canadian banks are very well capitalized, and are performing well. There will always be investors who are going to buy Canadian, or who prefer to buy Canadian, regardless of the economic climate. Really, I think it comes down to a personal decision.

Vikram Barhat