Home country bias

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Home country bias is the tendency for investors to focus their investments in their domestic markets.[1] Financial theory suggests that investors should construct their asset class exposure in line with global-market capitalization.[2] Yet investors from most countries over-concentrate their portfolios in domestic assets. The home bias phenomenon occurs all over the world,[2][3] and is often intentional. This article documents the phenomenon for Canadian investors, and then discusses pros and cons of overweighting domestic securities in fixed income and equities.

Quantifying our home bias

Canadian equities represent about 3% of world stock markets in September 2021.[4] Similarly, Canada represents 3% of the world's fixed income markets.[5] Canada is the 8th largest stock market by capitalization[6] and the bond market ranks in the world's top ten.[7]

Nevertheless, as of Feb. 2014, Canadian investors (including institutions) had a 59% domestic allocation for equities.[2] By late 2016 the figure was about 50%.[8] By 2020 the figure was still above 40%.[9] The home bias in equities is probably higher for individual investors, since Canadian defined benefit pension plans, for instance, held only about a quarter of their equity allocation in Canada in 2020.[10]

In 2010 Canadian investors (presumably including institutions) had a 89% domestic allocation for fixed income.[3] By 2020 the figure was about 84% for all Canadian investors including institutions[11], and presumably even higher for retail investors.

Home bias in fixed income

For Canadians, keeping all fixed income domestic has the following advantages:

  • matching the currency of expenses to the currency of assets[12]
  • simplicity
  • the domestic fixed income market is reasonably diversified by issuer type (federal government and agencies, provinces, municipalities, corporate), term (short, medium, long), credit rating, etc. (e.g., see Canadian versus global bonds); although see [13]
  • the domestic market has historically provided returns and volatilities comparable to developed markets as a whole[note 1]; although see [14]
  • better investor knowledge of domestic markets
  • no exposure to foreign currencies, which would add greatly to the volatility of fixed income investments
  • no additional costs in the form of higher management expense ratios (MERs) or currency hedging costs

Therefore it appears that the home bias of Canadian investors in largely justified for fixed income. However certain investors may still want to consider adding some foreign bonds to their portfolios.

Home bias in equities

Vanguard research lists the following possible causes of home bias for equities:[3]

  • a preference for the familiar
  • corporate governance issues for overseas companies and (historically) high costs to access foreign securities
  • liability hedging (domestic investor spending is influenced by domestic inflation and interest rates)
  • multinational companies provide international diversification (this seems to work better for US or German investors than for Canadian investors[15])
  • limiting exposure to foreign currencies

Other arguments for investing mostly in Canadian equities are

  • the dividend tax credit (applies to unregistered accounts only)
  • no additional costs in the form of higher MERs or currency hedging costs

Arguments against too strong a home bias for Canadian investors are:

  • the Canadian stock market is highly concentrated in three sectors (energy, materials, financials) which are quite cyclical, and has significant under-representations in several other sectors, relative to the rest of the world
  • issuer concentration. The Canadian market has 39% of its capitalisation in the top-ten stocks[16], compared to 23% for the US market[17]
  • global diversification can reduce the volatility of returns because the correlations coefficients between Canada and global stocks are less than one (rolling 36-month correlation coefficients have varied between 0.37 and 0.87 over the period 1972-2014[2])

Each investor has to evaluate the pros and cons of a strong home bias versus global diversification for equities, taking into account his/her personal situation. Financial Wisdom Forum members have indicated allocations to Canada ranging from 0% to 100% within the equity part of their portfolios.

Canadian investors looking for a reference point based on substantial research can look at the proportions in VEQT, which contains about 30% domestic (Canadian) equities and 70% foreign ones. These proportions are aimed at minimizing portfolio volatility, but most of the benefit comes from the first 50% of global diversification (see Figure 6 in Hasanjee, 2023).[18]

Notes

  1. ^ For example, during the period 1993-2013, Canadian bonds returned 7% annualized with a standard deviation of 6% (data source: Libra Investment Management), whereas US bonds (hedged to CAD) would have returned 6% annualized, with a standard deviation of 5% (data source: Barclays US Aggregate Bond Index annual returns from the Bogleheads wiki).

See also

References

  1. ^ Home Country Bias Definition | Investopedia, viewed October 6, 2021.
  2. ^ a b c d Pakula et al., Vanguard research, Global equity: balancing home bias and diversification - a Canadian investor perspective, July 2014, viewed Dec. 29, 2014.
  3. ^ a b c Philips et al., Vanguard research, The role of home bias in global asset allocation decisions, June 2012, viewed Dec. 29, 2014.
  4. ^ MSCI ACWI All Cap Index, Factsheet, viewed October 8, 2021.
  5. ^ See page 45 ("Global Bond Market Outstanding - Share of Total") of Capital Markets Fact Book, 2021, viewed October 6, 2021.
  6. ^ Distribution of countries with largest stock markets worldwide as of January 2021, by share of total world equity market value, viewed October 6, 2021.
  7. ^ Credit Suisse Global Investment Returns Yearbook 2014, viewed January 1, 2015.
  8. ^ CIBC Asset Management, Making Canadian portfolios strong and free of home bias, November 2018, viewed October 8, 2021.
  9. ^ Calculated as follows: Size of Canadian stock market is 2.92% of $76,080,520M USD as of September 2021 (based on MSCI ACWI All Cap Index). Of this, foreigners own $953,187M in December 2020 (Table 11 in IMF's Coordinated Portfolio Investment Survey, link), meaning Canadians own $1,268,364M USD of Canadian stocks. Canadians also own $1,752,543M of foreign stocks according to the IMF. So about 42% of the equities held by Canadians are domestic.
  10. ^ Pension Investment Association of Canada, Asset Mix Report, viewed October 6, 2021.
  11. ^ Calculated as follows: in late 2020, the size of the Canadian bond market was $3,910,300M USD (Page 44 in Capital Markets Fact Book, 2021). Of this, foreigners owned $1,218,375M USD (Table 11 in IMF's Coordinated Portfolio Investment Survey, link), meaning Canadians owned $2,691,925M USD of Canadian bonds. Canadians also owned $501,091M USD of foreign bonds according to the IMF. So about 84% of the bonds held by Canadians were domestic.
  12. ^ Re: How much in Canadian equities?, by forum member Shakespeare, direct link to post.
  13. ^ Carrick., R. Canada's bond market: Too insular for its own good, The Globe and Mail, May 20, 2011, viewed December 29, 2017
  14. ^ Philips, C.B. et al (2014) Going global with bonds: Considerations for Canadian investors. Vanguard Research, viewed December 29, 2017
  15. ^ Rowland, P.F., Tesar, L.L., 2004, Multinationals and the gains from international diversification, Review of Economic Dynamics 7:789–826 (PDF)
  16. ^ S&P/TSX Composite (CAD) - S&P Dow Jones Indices, viewed October 2, 2021.
  17. ^ S&P Total Market Index, factsheet, viewed October 9, 2021.
  18. ^ Hasanjee B (2023) Canadian Home Bias -- A Case of Global Equity Diversification, Vanguard Investments Canada Inc., viewed July 21, 2023.

Further reading

External links

  • Bender, J., Ask Bender: Canadian Stocks vs. Global Stocks (Part I), September 6, 2016
  • Bender, J., Ask Bender: Canadian Stocks vs. Global Stocks (Part II), September 12, 2016
  • Bortolotti, D. Bias towards Canadian stocks is just fine, MoneySense, May 12, 2015
  • Bunce, J., Are you staying too close to home with your investments?, Morningstar Canada
  • Phillips, Hager & North Investment Management, Home Country Bias: Determining the Right Split between Canadian and Foreign Equities, June 2, 2016
  • "Global equity investing: The benefits of diversification and sizing your allocation" (PDF). Vanguard Research. February 2019.
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