Home truths about limited horizons

Fund Strategy - 13 June 2011 | By Vanessa Drucker

Windows on the world There is a powerful pleasure in recognising a well-known tune. Investors also like to hum familiar strains. From music to money, both individuals and most professional managers remain drawn toward their immediate surroundings - whether their own countries or regions, their states or villages, or even the firms where they work. The phenomenon, which behavioural psychologists would classify as a misplaced cognitive and emotional fallacy, can lead to risky choices and suboptimal portfolios. According to data from the Investment Company Institute, the mutual fund trade body, in 2010, Americans ploughed only 26% of their equity allocations into international funds, although non-American equities accounted for 58% of the global market.

John Graham, a professor at Duke University’s Fuqua School of Business, has studied the relationship between investor competence, education and home bias. He has discovered that, “when an investor feels more competent about investing in foreign assets, he is more willing to shift a portion of his assets overseas.” Graham’s survey data categorises investors according to educational levels; next he considers the impact of higher learning. Is education really a proxy for competence? “What does education buy you?” he asks. Books in themselves may not provide the practical relevance. It is not as if literature studies prepare students for financial decisions, but rather that those pursuing higher education are more likely to be cognisant of international affairs, and of the possibilities available for investing outside their own country. “It’s not the academic degree that counts, but the awareness,” he says. (Stateside continues below)

Which investors demonstrate the most open outlooks beyond their own horizons? Adrian Cronje, the chief investment officer at Balentine, an independent investment advisory firm in Atlanta, Georgia, observes that investors in Australia and Scandinavia have more progressive attitudes about international diversification, while those in America and Britain lag. In part, that blinkered view derives from the consultants who intermediate for clients, slicing and dicing the universe into pieces. It takes a brave endowment or investment committee manager to step aside from the herd, and plunge into non conventional asset classes.

Excuses, excuses
Managers are equipped with a ready arsenal of excuses. The following three rationales may sound plausible enough, but they harbour some deceptive underpinnings. Buy what you know. Warren Buffett has long advocated that approach. One surely does have keener insights into conditions in one’s own country. Americans tend to follow the shifting home political landscape closely, with developed opinions on whether Democrats or Republicans, or particular politicians, are more supportive to business and economic policies. Drilling down to the workplace, employees may assume a superior grasp of the expectations for the firms where they are employed. That herd mentality operates at the street level, too. Logic suggests investors put their money into local enterprises, where their neighbours work. Investors know that their fortunes will increase if their local companies do well, so those who invest locally are more likely to keep up with the Joneses.

While citizens or employees might enjoy deeper knowledge of their own countries or companies, what they often forget is valuation. Timothy Parker, of Regency Wealth Management in Midland Park, New Jersey, warns that local enthusiasts may be overpaying. In theory, managers should be able to discount richly valued investments more rigorously than retail clients themselves.

Another peril is concentrated risk. The ultimate form of home bias would be to own a disproportionate quantity of company stock, which compounds the danger of tying the prospects for one’s job and one’s portfolio together. Safer institutions. Americans take comfort in high standards of stability and shareholder protection, transparency, disclosure and operational requirements, property and contract rights, and bankruptcy processes. Despite shortcomings, those frameworks are incomparably sounder than equivalents in emerging markets like China or Russia. If benefits like good corporate governance are already priced into securities, “there should be a risk/return trade-off,” Graham points out. In other words, riskier places should have baked in higher returns. Multinationals generate their own form of diversification. Managers frequently maintain that large, global enterprises, like General Motors or Proctor & Gamble, offer the benefits of all the economies into which they are selling, as a short cut to diversification. But even among the largest multinationals, their revenue streams do not systematically represent all countries. Moreover, outsiders are unlikely to have knowledge of the individual firms’ approaches to hedging currencies. (It should be added, though, that buying into multinationals can also be a sensible way to finesse overpaying for some hot emerging markets when they are in favour).

Equities and other asset classes
Most American investors have at least grown accustomed to the concept of international equities. That is not to say they are fully embracing foreign stocks. Taking a GDP weighting as a useful yardstick, Morgan Stanley data indicate that emerging markets alone contributed 36% in 2010, which is up from 21% in 1999. “Not even institutional investors weight them to that extent,” says Cronje. According to global MSCI data, China’s GDP constitutes 9.26%, Germany’s 6.31%, Britain’s 4.10% and America’s 26.76%. It would be rare to find American managers whose portfolios tracked those international proportions.

Notwithstanding, it is in fixed income that the parochialism really shows up. “One of the most underrepresented and misunderstood classes in American portfolios is emerging market bonds,” says Cronje. It is, however, an avenue for investors to gain exposure to positive real interest rates, denominated in currencies with potential to appreciate. Cronje’s clients are more receptive to the idea, having grown impatient with the paltry level of American interest rates.

“We try to show them that volatility of domestic fixed income has been rising.” Finally, currencies offer another route for diversification. At Balentine, strategists regard the globe as bipolar, with America, Europe and Japan facing demographic headwinds and other challenges. Their key is to protect against the debasement of developed world currencies.

Yet home bias still rules. With the whole world as one’s oyster, why not take advantage of a greatly multiplied opportunity set, with many more investments to choose from?

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