Is it Right to have a Home Bias?
There has been a surge in negative sentiment towards investing in the US from non-US investors. The country’s tariff policy has scared off investors, causing the dollar to weaken and increasing volatility in US yields. After more than a decade of US equity outperformance, is it time to invest your capital at home?
People invest in what they are comfortable with, and what people are comfortable with is what they are familiar with. People are familiar with where they live, so naturally, people invest in their domestic country at a higher rate than in other countries, leading to a ‘home bias’. Both retail and institutional investors do tend to have a home bias, though it occurs at a higher rate for retail investors. If the market were fully efficient, we would see no cases of home bias, as investors would always move capital to the highest risk-adjusted return portfolio. Risk-adjusted return accounts for the volatility of returns.
As different countries have different volatilities and expected volatilities, the correlation between countries compared to assets within a single country is lower. However, correlations between countries have been rising over time as globalization has progressed.
There are many reasons why investors should have a home bias, as well as why they should not have a home bias, depending on the investment and market structure.
Why Does Home Bias Persist?
A simple reason why people naturally have a home bias is that their home market is more accessible. A Canadian retail broker is going to provide access to Canadian exchanges but may not provide access to European exchanges. Today, there are many ETFs that allow for exposure to countries or regions of the world through domestic exchanges, but many retail brokers still have limited access to individual non-domestic stocks, restricting international investment opportunity to index-based investing.
A good reason why a home bias can occur is because of lower taxation for domestic investment. Countries commonly provide beneficial tax rates for investments that are from domestic companies. As well, countries can look to tax foreign investors, resulting in a higher effective tax rate for the investor; for example, the US dividend withholding tax, which is 30%, or 15% in Canada due to a Tax Treaty. However, the tax treaty is being looked at by the current American government, which would impact Canadian and non-American investors if changed. The likelihood of changing tax policy does create added risk.
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The Currency Factor: How FX Impacts International Investing
Currency risk is another factor generally in favour of a home bias, at least in a developed country like Canada, with a stable currency. When investing in other developed countries, currencies move relatively slowly, barring significant events, meaning currency risk is reduced, but not eliminated. Investing in developing or emerging markets does carry the risk of significant currency devaluation and fluctuations. Even when a country’s stock market does perform well in nominal terms, the same is not necessarily true once accounting for foreign exchange fluctuations. Foreign exchange fluctuations will impact companies that are both listed in foreign currencies as well as if they have operations that rely on foreign currencies. Many international company’s default to using the US dollar as a functional or operational currency.
The Case Against Home Bias
Having a home bias does carry many negative effects. Simply, you are reducing your total possible investable assets. A significant reason why one may look to invest in non-domestic assets is that international investments have a lower statistical correlation. A lower correlation is beneficial for diversification. Many institutional investors adhere to Modern Portfolio Theory, which aims to have optimal risk-adjusted returns through combining uncorrelated returns with the goal of reducing volatility for a given return level.
International indexes have increasingly become more correlated over time due to globalization. Increasing correlations between international and domestic equities reduce the benefits of diversifying into international markets. Domestically listed companies more commonly have international operations and direct or indirect exposure via supply chain or human capital. For example, from KeyStone’s research a small-cap 
NTG Clarity Networks (NCI:TSXV) has exposure to both Egypt and Saudi Arabia despite being a Canadian listed company.
Sector Concentration: A Hidden Risk in Domestic Portfolios
A factor in the uncorrelated returns on an index level is that indices and economies in general have different sector weightings. The US-based S&P 500 has a 32% information technology sector weighting, whereas, the Canadian-based TSX Composite has a 33% financial weighting. Compared to the MSCI World Index, which is a market capitalization-weighted index of ~85% of the world’s float market capitalization, the US is overweight Information Technology and Canada is overweight financials. This is no surprise, the biggest players in the US are the megacap technology players, Microsoft (MSFT:NASDAQ), Alphabet (GOOG:NASDAQ) and Nvidia (NVDA:NASDAQ)a technology concentration whereas in Canada, the Big Banks TD (TD:TSX), Royal Bank (RY:TSX), and Bank of Montreal (BMO:TSX) are the big players. It should be noted that, due to being large-cap and market-weighted indexes, mid and small-cap companies are overlooked.
A key benefit of investing internationally is exposing yourself to sectors that are not as prevalent domestically. Investing internationally can also expose an investor to an increased level of risk.
Country Risk: Understanding the Global Playing Field
Different countries have different levels of expected risks, whether it is due to political, economic, or social risk, it has an impact on a country’s risk level. The underlying reason can vary greatly depending on the country and can have intertwining risks. Political repression can lead to social unrest, which could appear in the form of peaceful protests to terrorism. Ultimately, a country which is riskier to operate in should provide a higher expected return in exchange for taking on the added risk. Quantitatively, this can be expressed through a country risk premium. NYU professor, Aswath Damodaran, created and updates annually an estimate for country risk, based on the default spread of the country’s bonds compared to the US. While there are assumptions baked in, it can give a quantitative picture of the level of risk of investments by country. Under this model, developed countries like Canada do not have a country risk premium, whereas a developing country like Mali has a 12% country risk premium. Analyst’s can use these premiums to adjust their models to account for the additional risk, a higher risk premium the more risky a country is.
Stock Picking and International Investing
As a DIY investor, not relying on an index, you can achieve exposure to international operations more easily by selecting individual companies. As emerging and developing countries do not have equity markets as developed, companies commonly list or cross-list on Canadian and American exchanges, or are headquartered in Canada or the US, with materially all operations being outside the country. Building a portfolio through individual stocks can allow for a more balanced sector weighting within a portfolio compared to a purely passive broad-based index like the S&P 500 or TSX Composite, and allow for the ability to select domestically listed companies with international exposure. This ultimately allows one to gain exposure to different risks and return profiles not seen in a broad-based passive index.
Don’t Let Borders Define Your Portfolio
Investors should not be fearful of looking abroad for investment opportunities, as having a strict domestic criteria limits opportunity and can increase risk due to the lower diversification of potential assets. At the same time investors need to realize that countries have different risk levels in general and can increase risk depending on the country. Companies which are domestically listed but have significant international exposure provide ease of investment and an abnormal risk profile compared to other domestic companies. The key is not abandoning home, but not being chained to it either.
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