Deceptive familiarity

“Many Asian investors who chose to invest primarily in home markets did not benefit from the uptrends in the US and Europe.”

Most private investors invest too much in their respective home markets and do not diversify enough abroad. While investing in what is familiar may feel safe, this so-called ‘home bias’ can significantly hurt portfolio performance.
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Thomas Kaegi
Head, Distribution Management APAC,
Investment Products & Services, UBS Wealth Management

Over the last three years, Asian investors have struggled to reap the benefits of positive global equity markets. US and European stock markets have been chasing new highs, while Asia ex-Japan equity markets on average have been virtually flat over the last three years. Since the start of 2011, MSCI World, a broad index of developed stock markets, has delivered a return of 40% in USD (as of 13 March 2014), while the Asia ex-Japan equivalent was virtually flat over the same period. This is equivalent to an annualized outperformance of 11% (see Fig. 1). Therefore, many Asian investors who chose to invest primarily in home markets did not benefit from the uptrends in the US and Europe. In addition, their portfolio exhibited much higher volatility, as Asian stocks have fluctuated much more than Western markets.

Home bias is not unique to Asia

Whether in countries with large and deep equity markets (such as the US, Japan or the UK), or in countries with much smaller equity markets (such as Singapore or Hong Kong), domestic investors concentrate heavily on local stocks in their portfolios. Studies suggest that US investors on average hold around 70% of their equity portfolio in US stocks. However, the US stock market accounts for only 49% of global stock market capitalization (see Fig. 2). Studies for other countries usually indicate a home bias of 50–80%, but for these markets the negative effects of home bias are more pronounced since they are much smaller than the US equity market.

Home bias isn’t just found in equity investments, but also within the bond holdings of private investors. We observe a concentration in bonds of investors’ own governments, and in corporate bonds of domestic companies. In fact, the bias towards domestic bonds is even more pronounced than for stocks. This focus on domestic markets means that most investors are restricting their investment universe.

Diversification lowers volatility risk

One of the reasons why such a pronounced home bias exists is that many investors only invest in what they know. This isn’t bad advice, but it usually leads to portfolios that are not diversified enough – exposing them to a higher level of volatility and the possibility of underperforming a broader benchmark.

Also, smaller equity markets are often skewed towards certain sectors, so investors are overexposed to risks specific to those sectors. For example, over 50% of the stock market capitalization in Singapore and Hong Kong is in financial companies.

Thus, the ‘I only buy what I know’ behavior often results in bulk exposure, where investors hold stocks of just a handful of companies familiar to them. In addition, many investors have significant holdings in the stock of their employer, which may not be advisable because a large portion of their wealth is tied up in only one stock. More importantly, should their employer get into difficulties, the investors may not only lose their money, but their regular income too.

In the latest Year Ahead publication, UBS CIO Mark Haefele pointed out: “It can be easy for investors to underestimate risks close to home, due to familiarity. Home bias, however, can lead to excess risk for no commensurate return. Investors should avoid home bias by diversifying globally.”

While it would be optimal if investors diversify their assets along the CIO’s global asset allocation templates, a certain home bias can be justified. Currency effects and particularly tax laws often benefit investments in the home equity market. Having said that, even after accounting for these factors, most investors invest too much at home. We prefer Asian investors to put not more than 50% of their equity investments into Asia ex-Japan stocks and also diversify their holdings within Asia. To compensate the lack of familiarity, investors should consider delegating the management of foreign equity investments to experienced fund managers or make use of Exchange-Traded Funds (ETFs).

What about currency risks?

The impact of currency fluctuations should not be dismissed. Fixed income investments, in particular, face the risk of FX swings eradicating capital gains and interest payments. UBS CIO Mark Haefele recommends fully hedging currency risks for both equity and bond investments. In the current market environment, hedging costs are negligible for most currency pairs. At UBS, we offer currency hedged share classes for most funds, while investors in single stocks and bonds can consider various FX solutions or a loan to hedge the risk of currency moves.

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UBS-managed solutions such as Investment Mandates or Strategy Funds follow the CIO’s recommended asset allocation and therefore have no or only a limited home bias, depending on the solution. To find out more, please visit http://www.ubs.com/sg/en/wealth_management/your_goals-our_solutions/investing/prof-port-mng.html