Strong home bias a disadvantage?

By Atul Tiwari | October 16, 2012 | Last updated on October 16, 2012
3 min read

Home is where the heart is. Charity begins at home. And, apparently, home is also where investors place most of their money—and that’s not necessarily in their best financial interests.

The rationale for geographic diversification is clear—Canadian stocks are exposed to Canadian economic and market forces, while stocks domiciled outside of Canada offer exposure to a wider array of such forces. Differing markets produce returns that vary from those produced by Canadian stocks. In a perfect world, a Canadian investor directly realizes a diversification benefit: lower volatility.

Still, home bias remains strong here. Canadian investors, on average, held approximately 60% more homegrown stocks than the Canadian percentage of global market capitalization—5% as of December 31, 2010.

And in 2010 (the latest available holding data from the International Monetary Fund at the time of the study), Canadian investors allocated a whopping 65% of their equity holdings to Canadian equities.

These statistics represent an opportunity for advisors to connect with clients; to sit down with them to consider whether they should increase allocations to international stocks. Start with a holistic evaluation that includes the following six factors:

  • 1. Sector variation from world market

    Investors can benefit from greater international diversification if their domestic market is concentrated in just a few sectors. One way to gauge sector diversification is to look at how sector concentrations deviate from the MSCI All Country World Index (ACWI).

    In Canada, there are significant differences between the domestic weightings of various sectors and their representation in the MSCI ACWI. For example, the Canadian market is underweight the global technology market by 10.7%.

  • 2. Issuer concentration

    Certain markets can be heavily concentrated in just a few securities. In Canada, given our relatively small market, broad-market index returns are dominated by the largest firms.

    For example, as of December 31, 2011, Royal Bank of Canada accounted for 5.33% of the MSCI Canada Index, TD Bank for 4.84%, and Bank of Nova Scotia for 3.94%.

  • 3. Transaction costs and 4. Liquidity

    While transaction costs in Canada aren’t the highest and the Canadian market is relatively liquid, the data suggests there’s room for improvement. These are important considerations because investors in even moderately liquid markets may benefit from increased global diversification.

  • 5. Tax considerations

  • Taxes generally can be broken into four categories: capital gains, dividends (from equities), interest income (from fixed income), and transaction or stamp taxes.

    The degree to which an investor is exposed to additional taxes by virtue of foreign investment helps determine whether it’s advantageous or disadvantageous to increase foreign exposure.

    Compared with other countries, Canadian investors fare relatively well with regards to taxes. Capital gains on international securities are taxed in the same way, and at the same preferred rates, as capital gains on domestic securities. Domestic dividends are taxed at a significantly lower effective tax rate than international dividends, but international interest and domestic interest are taxed at the same rate in Canada. Canada also doesn’t impose a transaction or stamp tax on securities.

  • 6. Other market-risk factors

    Finally, consider country-specific systematic risk, like political turmoil or poor corporate governance practices in an investor’s home market. They can be difficult to quantify, but must weigh into the decision process because they have potential to add significant risk to a portfolio with a high exposure to domestic securities.

    We used investor protection rankings as a proxy for corporate governance, and the results show strong investor protections in Canada. That might be viewed as justification for home bias, but the rankings shouldn’t be viewed in isolation.

    Taken together, these quantitative factors—specifically, the relatively high levels of sector and security concentration and the benefits of global diversification—suggest investors in Canada may benefit from increased international allocations.

The evolution of equity home bias

Evolution of equity home bias

Source: International Monetary Fund’s Coordinated Portfolio Investment Survey (2011), Barclays Capital, and Thompson Reuters Datastream.

Sector concentration by country, as of December 31, 2011

Consumer Discretionary -6.4% 0.9% -3.5% -7.5%
Consumer Staples -7.4% 0.3 5.5 -1.7
Energy 14.3 0.1 9.0 -4.5
Financials 14.2 -4.1 -2.1 22.2
Health Care -8.4 2.6 -0.6 -5.6
Industrials -5.0 -0.3 -3.9 -4.4
Information Technology -10.7 6.4 -10.6 -11.6
Materials 14.07 -4.3 3.2 18
Telecommunications Services -1.9 -1.6 2.6 -2.6
Utilities -2.7 0.0 0.3 -2.1
Sum of absolute deviations 85.1 20.6 41.3 80.2

Notes: Yellow shading denotes deviations of between 5% and 9.99%; red shading denotes deviations of 10% or greater. ACWI = All Country World Index; IMI = Investable Market Index.

Source: Vanguard calculations, based on FactSet Research Systems data as of December 31, 2011.

Atul Tiwari is managing director, Vanguard Investments Canada.

Atul Tiwari