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Home is where the heart is…

Feb 18 2019 14:46
Ainsley To and Deon Gouws

There is strong evidence that investors around the world favour their home market and this is reflected in their portfolio holdings. 

The phenomenon is known as home bias and has remained a puzzle in academic literature for decades. 

Despite barriers to international investment continuing to fall, most individual investors have remained overly invested in their domestic market. 

There are certainly practical reasons why some SA investors might not be invested in foreign stocks (due to individual constraints or liability matching, for example). 

But for those who can, the balance of evidence suggests that global diversification is worthwhile.

Returns for an unhedged investor

Chart 1 compares real returns in rand and return volatility (as a proxy for risk) across 26 foreign markets. 

Universe consists of: Australia, Austria, Belgium, Canada, China, Denmark, Finland, France, Germany, Hong Kong, India, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, UK, US. From a returns perspective there is no blanket statement that can be made about foreign exposure – some individual markets have outperformed the SA market over this period and others have underperformed, with a few extreme outliers on both sides. 

However, the picture becomes more interesting when looking at global investments. The global portfolio, which represents the MSCI All Country World index (ACWI), has had higher returns than the local market. }While the ACWI is easily investable, it has had large country concentration (the index is currently over 50% invested in the US). 

For reference, the chart also includes EW, an equally weighted country portfolio, which is more representative of broad foreign country exposure.

(The EW portfolio does not include all the markets in the MSCI ACWI but is to represent the experience of the average country in the list. The portfolio was rebalanced monthly.)

Both global portfolios have achieved a higher real return than the SA market over this period, illustrating this is not simply due to the dominance of the US market in global market capitalisation.

Risks for an unhedged investor

A caveat to simply comparing returns is that historical data is often unreliable as estimates of the future.

On the other hand, the volatility of equity returns has been more prone to mean reversion over time. 

When comparing volatility (the horizonal axis in chart 1), it is no surprise that the SA market is on the lower end of the spectrum (further to the left) relative to other individual country portfolios since the unhedged foreign markets are explicitly exposed to currency risk. 

However, in the case of both the global and EW portfolios, the risk reduction from diversification outweighed the additional currency risk, thereby resulting in lower overall volatility than for the domestic market. 

This was not to the detriment of return – namely both global portfolios had a better risk-reward-ratio than the local market.

There are of course many dimensions to risk that are not captured by volatility. 

Another perspective is to look at the returns of a global portfolio during the worst periods for a local market investor. 

Chart 2 shows the returns during the worst periods for the SA market compared to the returns for the global portfolio during those same periods and shows this across various investment horizons. 

Many of the worst months for the SA market coincided with difficult periods globally, as can be seen on the left of chart 2 – during the worst periods (5th percentile) of 1-month returns for the local index, the SA market averaged -11.7% and the global portfolio was also down an average of -3%. 

However, for longer-term investors, the global portfolio was increasingly diversifying – when investing for longer than two years, real returns for the global portfolio were positive during the worst times for the local market. 

For example, the average return during the local market’s worst five-year periods was -11.5% versus +79% for a global investor in rand terms. 

A similar relationship is seen when comparing the EW portfolio. 

In summary, global diversification helps reduce long-term tail risk in investor outcomes.

ToGouws
ToGouws
ToGouws


Concentration risk under the bonnet

Other benefits to diversification can be seen when we drill down to the stock and sector level. 

As with many individual countries, the SA market has a narrow universe which is dominated by a few large names (bottom left), with the top 10 stocks making up over 60% of market capitalisation. 

This is not the case in the global index, where the weight in the top 10 is a much smaller proportion. 

A global investor has a broader opportunity set to capture the equity risk premium.

The SA market is also quite sparse from a sector exposure perspective – using Global Industry Classification Standard (GICS), the MSCI South Africa contains zero Utilities or Information Technology stocks (Naspers* is part of the new Communication Services sector) and the Energy and Industrials sectors only contain one stock each.

This leads a purely domestic investor to be exposed to a much smaller number of economic drivers due to the narrow group of stocks available to them.

Conclusion

“Diversification is the only rational deployment of our ignorance” – Peter Bernstein

It is human nature to relate the safe with the familiar – and in terms of perceived safety there is no place like home. 

When it comes to investing, however, what feels emotionally comfortable is rarely the optimal choice. 

Global diversification is not a panacea that removes all risk – equity markets can be highly correlated during short-term crashes. 

Yet short-term volatility, however painful, is a less significant risk than long-term impairment of wealth. 

And in this regard, global diversification is an extremely effective way to improve outcomes.

It is consistent with history for any one country market to go through structural decline for multiple decades. 

For investors who can’t forecast with certainty which exact countries to avoid, the best approach to reduce risk is to diversify globally.

All else being equal, the starting point for an equity allocation should be the global market, not the domestic one. 

Ainsley To is head of the multi-asset team at Credo Wealth.

Deon Gouws is chief investment officer at Credo Wealth.

*finweek is a publication of Media24, a subsidiary of Naspers.

This article originally appeared in the Collective Insight supplement in the 21 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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