There’s no place like home … except in a portfolio

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While some investors might feel tempted to stock their portfolio exclusively with equities of domestic companies, a so-called “domestic bias” or “home bias” strategy can be harmful in the long run, experts warn.

“Diversification is always beneficial to your long-term ability to achieve your investment goals. So, if you’re concentrating your portfolio by running a home bias, then you’ve got an inefficient portfolio. You need more diversification,” stresses Michael Sager, vice-president, multi-asset and currency management with CIBC Asset Management in Toronto.

“Diversification mitigates risks [and] improves your expected performance over the long term,” he adds.

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There are many reasons why high-net-worth investors, including family offices, might be tempted towards a domestic bias. A common refrain is familiarity, especially regarding equities, because domestic investors are more familiar with the representative company and its performance.

“Particularly in Canada there’s been a philosophy that says, ‘Buy the Canadian banks and you can’t go wrong,’ so I think that is something people have had a level of comfort in,” says Wayne Kozun, chief investment officer with Forthlane Partners Inc. multi-family office in Toronto.

“During the global financial crisis in 2008, the Canadian banks held up pretty well compared to the U.S. or U.K., where there were many instances of financial institutions having to be bailed out by their governments,” he explains.

Tax advantages might also be a consideration, as Canadian dividends are taxed at a lower rate than foreign dividends.

Domestic bias reasons differ for equities versus fixed income

Sager says the reasons behind a domestic bias can be very different for equities and fixed-income portfolio investments.

For example, with respect to equities, a domestic bias can result from factors like greater familiarity with prominent domestic names, compared to currency risk and seemingly opaque foreign investing rules. For fixed-income investments, there can be a desire to hold domestic assets to match domestic liabilities.

Private individuals and charities often like investments with high-income yields, and the Canadian market offers relatively higher yield investments compared with the rest of the world, which might also contribute to a domestic bias, says Richard Maitland, a partner and head of charities with Sarasin & Partners in London, England.

But with capital gains taxed at a lower rate, it is also a very tax inefficient way to take a sustainable withdrawal from a portfolio. So, a lower yielding portfolio consisting of international investments is an attractive proposition for private money, he adds.

Sectoral diversification important in a portfolio

One aspect of portfolio theory says that investors should own stocks that are representative of the entire market. But as Canada only represents 3 per cent of global markets, 97 per cent of the equity market is outside of Canada. Therefore, a domestic bias is not representative of the global markets, says Kozun.

Canada is heavily weighted in only three sectors, he notes. Financial companies, including big banks and insurance companies, represent about 31 per cent of the S&P/TSX composite index. Energy is at about 18 per cent, and Materials, which is primarily in gold, is about 12 per cent of the S&P/TSX composite.

While the Canadian equity and bond markets might be the best performing in a given year, “over the long term, there is not a repetitious and persistent performance,” says Sager.

“When you delve into the specific sector exposures that you get in Canada versus other markets, there are some things that we’re noticeably lacking. The biggest thing is health care,” says Kozun. Since western countries have an aging population, it is important to have representation in healthcare and pharmaceuticals, he notes.

The health-care sector in Canada represents only about 0.4 per cent of the Canadian S&P/TSX composite index, whereas the global health-care sector represents about 13 per cent of the global MSCI All Country World Index (ACWI), Kozun says.

There is also much lower exposure to high-profile technology companies in Canada, compared to the United States. Information technology is only about 6 per cent of the S&P/TSX composite index, compared to about 21 per cent of the global MSCI ACWI market, so a domestic bias would not be representative of that important sector either, says Kozun.

“If you’re a family that is trying to protect yourselves against inflation, you need your portfolio to represent the things you’re spending your money on, which is probably not as skewed towards mining stocks, oil stocks or banking as the Canadian equity market is,” says Maitland.

“A more globally-diversified equity allocation would increase exposure to a number of sectors that have good long-term growth credentials and which impact Canadian consumers, but which are hardly represented by the Canadian equity market,” he adds.

Global diversification in stages

Investors that are reluctant to diversify might want to do so in stages. One potential starting strategy is to go to what might be perceived as a relatively safe foreign location, such as the United States.

The U.S. has done very well in recent years, and now represents about 60 per cent of the global MSCI ACWI market. Adding equities from emerging markets should, in general, provide even higher returns, but that can also add more risk, says Kozun.

If a Canadian investor has 100 per cent of their savings in Canadian equity, then their return will essentially be dominated by trends in the Canadian market. By adding equities from another country whose economy is uncorrelated to Canada into the mix, this provides two different economic drivers of returns, says Sager.

Different sectors add another component to the diversification. For example, mixing international healthcare, finance, technology and energy provides both sector and country performance, which will hedge performance because all components of the portfolio will not rise and fall together.

Fixed-income instruments, including government and corporate bonds, global bonds, real estate, commercial mortgages, private debt, and emerging market debt, also provide the opportunity for greater geographic diversification, says Sager.

“Even if it’s only Canada, U.S. and the European Union, you’re complementing your portfolio and it’s a better portfolio, in our opinion,” he says.

The importance of multiple strategies to diversify

Another strategy to help investors reduce domestic bias is to have foreign currency exposure. Although having foreign currency exposure can be thought of as being risky, it acts as a hedge in periods of crisis.

In troubled times, there tends to be a flight to quality on the most liquid currencies, such as the U.S. dollar, the Swiss franc and the Japanese yen, so having foreign currency exposure is a good diversifier in extreme down periods for the market, Kozun explains.

“When we talk to family offices, we always emphasize the importance of investment breadth. By that we mean have as many different sources of return in your portfolio as possible,” says Sager.

Every portfolio is different. The challenge is to figure out what an individual or family portfolio is trying to achieve in the long term.

The questions to ask include, “What are the goals? What do you already have in the portfolio in terms of risks and potential returns? How can we complement those risks and returns in a way that’s going to be additive to your opportunity set? How do we get from here to there by maximizing the breadth or the sources of opportunity in that portfolio?” says Sager.

“You have to think globally, sectorally, thematically, we would argue, to build a modern-day portfolio,” stresses Maitland.

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