Is investor home bias healthy?

It is well known that most investors overweight their home markets. Recently some research on UK pension funds highlighted that their allocation to UK equities was at the lowest it has ever been, with DB schemes having just 1.4% in UK stocks.

However, if you do the maths, as we did, you can work out that even they remain overweight the UK versus a global equity market benchmark. It’s just their equity allocation as a whole has collapsed, to just 13%.

So, should they be cutting their allocation even more? Should we all be more rigorously examining our portfolio and scaling back our UK equity allocation to its 3.8% weight in the MSCI World Index?

Here two of our analysts debate the issue…

Go for growth – Ryan Lightfoot-Aminoff

One of the most well-worn investing expressions is that diversification is your only free lunch. If investors opt for a significant domestic bias, they are effectively forgoing this potential benefit.

A domestic bias is effectively investors clinging to the comfort blanket of familiarity, but in doing so, I’d argue they are doubling down on risk and failing to allocate their capital rationally.

For most investors, much of their current and future wealth is tied into the strength of the domestic economy. Not only will their earning potential be heavily influenced by how well the UK is doing, but so will the value of most individuals’ largest store of wealth, property.

Therefore, when choosing where to allocate additional capital, why add further to this risk by skewing a portfolio towards the UK? This simply exposes all areas of one’s wealth and earnings potential to the same risks.

Such risks could stem from economic shocks or politically induced volatility. We can demonstrate this with a recent example. The UK's ‘mini-Budget’ in 2022 sought to boost economic growth through lower taxation and de-regulation.

However, this was poorly received by the markets due to a lack of detail on how it would be funded. This caused a sharp decline in the value of sterling, falling to a record low versus the dollar, and led to a sharp rise in mortgage costs as the bond market struggled. This caused pressure on property values as well as a pullback in the UK stock market.

For investors with a strong domestic bias, their personal balance sheets would have taken a substantial hit, both through declining house prices and a falling domestic stock market.

However, investors with a more internationally diverse portfolio would have fared much better. Not only were overseas companies almost entirely unaffected by the short-term volatility of UK politics, but the sharp drop in sterling would have actually increased the value of foreign investments when translated back.

Therefore, while investors would have still taken a hit on their domestic holdings, the international investments would have been largely unaffected and in fact, potentially have seen an increase demonstrating the benefits of diversification.

Furthermore, by diversifying internationally, investors are able to access a much broader pool of companies and industries. For example, the UK market has a significantly lower weight in technology companies than the global average, and especially the US.

The sector has been enjoying a period of secular growth over several decades now, and this is unlikely to reverse any time soon. By sticking to the UK market, investors are likely to miss out on the exciting growth opportunities in technology, with firms increasingly looking to the Nasdaq to list, as we discussed in a previous article.

It is not just the growth from specific sectors investors could be forgoing by having a domestic bias. Around two-thirds of global GDP growth has come from emerging markets in the past decade, with countries such as India and Vietnam helping drive this as they benefit from economic reforms and excellent demographics.

The UK, meanwhile, is a more mature economy, and is growing at an annualised rate of 0.9%, versus 6.7% and 6.9% for India and Vietnam respectively. Should investors wish to capture these significantly higher growth rates, a diversification overseas may be a solution. 

Vietnam Enterprise Ord (LSE:VEIL), which published results this week, offers access to Vietnam’s GDP growth at a wide discount to NAV. Ashoka India Equity Investment Ord (LSE:AIE) is one option for Indian exposure, and we published a full note on the trust recently. Other options include abrdn New India Investment Trust Ord (LSE:ANII), which has seen improved performance this year but still trades on a wide discount (in contrast to AIE). We will be publishing a full note on the trust shortly.

In conclusion, while the familiarity of a domestically focused portfolio might feel comforting for investors, it actually invites significant risks by concentrating all their wealth under one jurisdiction, meaning the risks of something going wrong far outweigh the potential benefits. By diversifying globally, investors can access a broader range of opportunities, hedge against domestic risks, and ultimately build a more resilient portfolio.

Ryan Lightfoot-Aminoff

Stick with what you know – Thomas McMahon

In theory, a barrister can’t defend a client if they become convinced they’re guilty. Is this rule always adhered to? We can only speculate. In any case, it is surely often true that an advocate has to make the best argument they can for a position that looks like a losing one.

So, how can you possibly argue that investors should depart from a globally diversified portfolio? There is this idea floating around that asset allocation explains 90% of portfolio returns, so surely it has been proven by The Science that it is impossible to beat a globally diversified approach?

Well, it turns out that this research has been misrepresented, and the study that originated that claim was actually looking at volatility. Updated research from 2000 suggests that around 40% of the variability of portfolio’s returns is due to asset allocation, with the rest being due to other factors such as asset-class timing, style within asset classes, security selection, and fees.

I don’t want to take us too far down that rabbit hole, but merely to observe that it is not a crazy idea to think you might do better by departing from a basic globally diversified asset allocation by leveraging other factors. In fact, one recent discussion among the analyst team here at Kepler centred on our best investment decisions in our personal portfolios. In each case it was the decision to sell everything (or near enough) when things were getting hairy. Timing the market, rather than time in the market – not so good for the asset managers, but maybe better for our pension funds?

Looking at the factors listed above – asset-class timing, style within asset classes, security selection and fees – I think a strong case can be made that each is easier to leverage in our home market, where our knowledge is deepest. In fact, we might even argue that because the UK is ‘too wee and too poor’ for the US or Chinese institutional investor to spend too much time thinking about it, a little local knowledge might go a long way.

One obvious misapprehension of the overseas investor is that the FTSE 250 index is a proxy for the UK domestic economy. In fact, it generates around as much of its earnings from overseas as it does from the UK. In this light, the recent low valuations of UK mid-caps were an obvious opportunity. Even if the UK outlook was to remain poor, there are lots of world-facing UK businesses which were and maybe still are a steal, and those valuations won’t remain so low indefinitely.

We spent a lot of time talking about this last year, while we expect such attention on US investing websites was lower. Over the past 12 months Mercantile Ord (LSE:MRC) has delivered share price total returns of 31%, Fidelity Special Values Ord (LSE:FSV) 21% and Schroder UK Mid Cap Ord (LSE:SCP) 20%. We think they still look attractively valued, and as the ‘doomster premium’ comes out of the market this valuation opportunity could unwind – and maybe the discount of 8–12% on the investment trusts too, which adds another level of value.

I also think that investors should think about the resources available to a manager to generate alpha. UK-focused UK-based managers are generally replete of analytical input. Managers based here who are investing globally may not be. A lot of value can be added by stock selection, and it simply has to become harder to add value when the potential opportunity set is wider and the analytical resource smaller per unit of opportunity.

Ryan refers to AIE above, and I think some of their success has to be due to the large team they have been able to devote to Indian equities. I think investors need to consider when investing in an overseas equity fund whether the managers are resourced well enough to cover their universe. This is much more likely to be the case in a UK portfolio.

If you doubt the potential of stock selection to add to returns, just look at the success of Rockwood Strategic Ord (LSE:RKW). It has delivered exceptional absolute and relative returns, with manager Richard Staveley working in a sector he knows like the back of his hand.

Have I convinced you, or indeed myself, that a home bias is healthy? I think that it is natural for a home bias to develop in a portfolio, as we know the opportunity set so much better and we are better able to add alpha by stock or fund selection and market timing.

It may well be that fees are lower too, which is a factor not to be sniffed at – an extra 50bps of performance each year means a portfolio will be 5% larger than it would have been at the end of 10 years.

While I would not necessarily like to encourage anyone to set out to overweight the UK, I don’t think it is anything to be feared.

Thomas McMahon