The Risk of Having a Home Country Bias

Canadian investors have historically maintained a home country bias on the belief that domestic companies will perform better than foreign companies and that foreign companies are riskier than domestic companies.

The home country bias is particularly evident when it comes to emerging markets, which have not only outperformed developed markets over the long-term but are also less risky.

Arguably, the home country bias is demonstrated in the $1.2 trillion Canadian mutual fund industry where less than 25% of all assets are held in foreign funds (including the US), with less than 2% in emerging markets funds.

Incidentally, at the beginning of 2015, Canada was the fourth largest equity market in the developed world and represented only about 4% of the world market capitalization. Comparatively, emerging markets collectively represented 35% of global market capitalization as of May 2015. Yet investors continue to maintain undiversified portfolios by investing almost three-quarters of their assets in Canada.

By having a high concentration of their assets in Canada, diversification risk is amplified. For instance, a comparison of Canada to the MSCI Word Index shows that the top ten companies by market capitalization represented over 36% of the total market capitalization in 2015, while the top ten companies on the MSCI World Index represented only 10% of total capitalization. In addition, the Canadian market is also subject to a strong sector bias, with the financial and resource sectors representing almost 75% of total market capitalization of the S&P/TSX Index.

The home country bias was even more prevalent up until 2001 when the foreign investment limit on registered retirement plans was capped at 30%. In 2005, the cap on foreign investments in registered plans was completely removed. Even then, the shift in favour of foreign investing has been relatively muted because investors have become accustomed to the perceived safety and security of the Canadian markets.

Having a home country bias has resulted in lower returns and greater risk for the typical Canadian investor. While emerging markets are riskier, they have outperformed the Canadian market over the long-term. A comparison of the performance of the MSCI Canada Index and the MSCI Emerging Markets Index in Canadian dollars shows that as of June 30, 2015, the MSCI Canada Index outperformed the MSCI Emerging Market index in only the three year and five year periods. However, in the ten year period, emerging markets outperformed MSCI Canada, indicating that it is advantageous to invest in emerging market for greater returns in the long-term.

Table 1: Emerging Markets Outperform Canada Over Long-Term

Source: MSCI, as of June 30, 2015

Emerging markets are also not as risky as perceived. Using standard deviation as a broad measure of risk, Table 2 clearly shows that the standard deviation for MSCI Canada has a similar double digit deviation as that of emerging markets at 14.04% and 17.56% respectively over the 10-year period.

Table 2 – Risk – Standard Deviation

Source: MSCI, as of June 30, 2015

Since the standard deviation may not be the best method of looking at risk, the Sharpe Ratio can be used to measure risk. The Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. By subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated. The risk free rate is based on BBA LIBOR 1M.

Table 3 – Sharpe Ratio

Source: MSCI, as of June 30, 2015

A higher Sharpe ratio tends to indicate a better risk adjusted rate of return. Although the ratio has come under criticism (portfolios without a normal distribution of returns), it is still considered the benchmark. Of importance to note, the MSCI Emerging Markets Index had a higher Sharpe ratio in the ten year period of 0.44%. This further supports the thesis of having exposure to emerging markets over the long term.

The investing public in Canada and the world by and large feel comfortable investing in domestic firms. On a return basis over the long term and a risk adjusted basis, emerging markets have clearly outperformed Canada. Strictly looking at market capitalizations, emerging markets are definitely a region not to be ignored since the region represents one third of total global market capitalization.

On a strict fundamental basis, as of June 30, 2015, price-to-earning ratios (P/E) were higher for the MSCI Canada Index versus the MSCI Emerging Markets Index. The P/E for MSCI Canada was 19.57 and 14.19 for the MSCI Emerging Markets Index. In addition, the price-to-book (P/B) ratio was also attractive for the MSCI Emerging Markets at 1.55 versus 1.92 for MSCI Canada – indicating that emerging market stocks are relatively cheaper.

Given better long-term performance, lower risk and cheaper valuations, the case can be made for greater exposure to emerging markets which can only be done by reducing the home country bias.

Rawn Lakhan

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