We have known for a long time that pension funds place a large domestic weight on their equity allocations, relative to what Modern Portfolio Theory—which encourages diversification of assets to lower investment risks—might suggest. But when we measured the extent of home bias we found an enduring trend, with investors’ equity weightings in their home markets far in excess of what theory would suggest.
One would not expect that returns from equity investment by some of the world's most highly-sophisticated institutional investors would be unduly domestically-focused, to the detriment of returns, but our latest research paper suggests exactly that.
We have known for a long time that pension funds place a large domestic weight on their equity allocations, relative to what Modern Portfolio Theory—which encourages diversification of assets to lower investment risks—might suggest. But when we measured the extent of home bias we found an enduring trend, with investors' equity weightings in their home markets far in excess of what theory would suggest.
We examined returns and weightings in the UK, Japan, Canada, Australia and the US over 11 years since the start of the Great Financial Crisis, using the FTSE All-World Index to analyze the market characteristics, performance and volatility of these five pension fund markets. In four out of five cases, the striking levels of over-weighting of domestic asset allocation led to under-performance.
Let's look at the weighting of equities first: Australia stands out for having the largest disparity between its allocation to domestic equities (52%) and its weight in the FTSE All-World Index (2%), which translates into a ratio of 26 times. The UK, Canada, and Japan were also all overweight by many multiples of their weighting in the index. (See Chart 1). The disparity is smallest for the US, although this largely reflects the world's largest economy accounting for more than half the weight of the global index.
Chart 1: Pension funds estimated allocation to domestic equities relative to total equity exposure and county weight in the FTSE All-World Index
Source: FTSE Russell as of December 31, 2018 and Thinking Ahead Institute, Willis Towers Watson.*
So having established the ubiquity of home bias, has it been good for investors?
Our analysis finds that between 2008-2019, of the five markets examined, the US was the only region in which a home bias would have strongly benefited investors. In fact, not having a US bias in portfolios would have been a significant opportunity cost for investors—US equities produced better risk-adjusted returns versus overseas equities for over 80% of the period examined.
As an aside, the US results need to be assessed within the context of the recessionary environment and the extraordinary monetary measures undertaken in the aftermath of the global financial crisis. This unusual set of conditions underpinned the surge in US equities at the expense of overseas equity markets and resulted in the appreciation of the US dollar.
But, as Table 1 below shows, in the UK, Japan, Canada and Australia, home bias was negative for investors, with domestic equities generating higher risk-adjusted returns than overseas equities for only 25% (and lower) of the period reviewed.
There remains an earnest academic debate about the causes of home bias. According to the Organisation for Economic Co-operation and Development there are several explanations for this persistent investor preference, including the desire to avoid exposure to exchange rate or political risk, the extra costs to hedge against these risks, regulatory barriers and asset-liability matching needs.
But our research confirms that in some the world's most sophisticated and transparent equity markets, investors tend to remain wedded to over-weighting their equity exposure, and in the last 12 years at least, this has cost them.
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