Venturing beyond home country bias.

Heading on an extended investment trip abroad? Here are some things to think about before you leave the comfort of home.

Preparing for your journey

Planning a vacation can take a great deal of preparation. The same goes for planning your investment allocations. For example, should you venture abroad or stay within your own country? In both travelling and investing, there are tremendous advantages and inherent risks.

Despite the benefits, investors in Canada, like in other major nations, tend to exhibit a “home-country bias” when developing portfolio allocations. Researchers have shown that this inclination has also appeared within domestic portfolios. A 1999 study by Coval and Moskowitz found that U.S. money managers preferred companies based closer to their own locations and that “one out of every 10 companies is chosen because it is located in the same city as the manager.” The most common explanation for this has been the limited information available—investors tend to buy what they know. However, with a vast network of publicly available information, this should no longer be a deterrent.

Discovering foreign markets

Based on market capitalization, Canada represents 3% of the world market. Some would argue that this means Canadian investors should have 97% of their assets outside Canada. However, due to a strong home-country bias and the hangover of the foreign content limit, Canadians have a disproportionate percentage of their assets in Canadian investments. According to a 2007 Greenwich Associates survey, allocations to non-Canadian equities totalled 29% in 2006, up from 25% in 2004. The foreign content limit was lifted by the federal government in 2005. However, even before this ruling, investors could have circumvented the foreign content limit with the use of derivatives—but most still chose not to.

Recent studies show that the average institutional investor’s foreign content holdings are still below the old limit of 30%. However, with many advantages to investing abroad, investors should take a closer look at the reasons behind their foreign property allocations, rather than taking them for granted.

Exploring your own country

The strength of the Canadian market and our dollar has played a role in keeping investors in Canada. The dollar has been bolstered by significant foreign and domestic interest in our natural resources. The S&P/TSX Composite Index’s annual rate of return for the past five years has been over 18%, so there has been little incentive for plan sponsors to look beyond our borders.

But keep the unique characteristics of the Canadian equity market in mind. It is cyclical and narrow, with the top 20 stocks representing 50% of the index by weight and the financials, materials and energy sectors constituting 75%(as of June 2007), according to UBS. These characteristics can contribute to increased volatility. Historically, adding foreign securities to portfolios has reduced volatility, based on the premise that correlations between global markets and currencies are low and will remain that way.

Navigating the risks

Even with greater access to market data, investing in other countries and currencies carries its own set of risks.

Currency Risk: Currency can be passively managed, actively managed or not managed at all. How to approach the currency decision depends on whether the plan sponsor wants to take that kind of risk or prefers risk exposure from other asset classes.

Interest Rate Risk: With foreign fixed income, keep in mind that interest rate risk is large and hedging may be beneficial. Domestic interest rates have the largest impact on a plan’s assets and liabilities and should be managed with the most attention.

Inflation Risk: Domestic equity acts as a better hedge against inflation than foreign equity; however, a depreciating domestic currency and price increases by foreign firms both contribute to imported inflation, which should not be ignored.

Following your itinerary

All of the points above must be taken into account in order to determine the appropriate allocation to foreign investments. The most crucial step is to decide the main goal of your pension plan: is it to maximize performance or reduce risk? You’ll also want to consider the plan’s demographics, funded status, and risk and return objectives. For example, if the plan’s goal is purely risk control, a defensive portfolio may have a large home-country bias. Protecting capital from high interest rates and preventing erosion of the portfolio value from inflation entail matching assets with liabilities in the same currency. As return maximization becomes more important, portfolios become less defensive and will have greater allocations to international investments.

It’s difficult to take your investment journey abroad when you’re used to the comfort of investing in something familiar. But as companies and economies become truly global in scope, it’s inevitable that investors’ allocations to non-domestic assets will rise. The real question is, how much will change and how quickly? If the past is any predictor of the future, it will change, but slowly.

Alexandra Jemetz is director of Canadian Research at Northern Trust Global Advisors, Inc. in Toronto. aop1@ntrs.com

For a PDF version of this article, click here.

© Copyright 2007 Rogers Publishing Ltd. This article first appeared in the October 2007 edition of BENEFITS CANADA magazine.

 

Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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