Adam Morrow, Portfolio Manager
It’s inherent in the wealth management profession to come up against home country bias in clients’ portfolios—it’s also prudent as advisors to discuss the associated pitfalls. Home country bias is the tendency for an investor to allocate to companies from their own region. It’s an area of behavioural finance explained by an investor’s familiarity with and experience of that firm in their home economy, information asymmetries, foreign transaction costs, and even a certain amount of patriotism. Indeed, it is a well-known phenomenon that individual investors tend to underweight international equities when constructing their portfolios; this can be costly. By adopting this bias, investors may inadvertently accept portfolios which aren’t entirely consistent with rational optimisation. For our American clients, this has posed less of an issue considering the US equity market represents 58% of global equity market capitalisation (the total value of all shares traded on the FTSE Russell All-World Index) and has, thus far, experienced superior economic performance and equity market returns. For our British clients, however, this leads to an even greater underweight to international equities given the UK’s percentage of global equity market capitalisation stands at 4%1 and is a less diversified market—with greater exposure to ‘old economy’ industries like banking, mining, and energy. Interestingly, if we were to consider the state of the global equity market at the beginning of the 20th century Britain would dominate with a 24% share, followed by the US (15%), and Germany (13%). A comparison from then to now highlights not only the changing fortunes of these countries but also underscores the benefits of diversification, a critical element of prudent wealth management. Imagine a British institutional investor missing out on the past 120 years of US investment returns…
Looking back only two decades, emerging markets (EM) comprised less than 3% of equity market capitalisation and only 24% of GDP; today, those figures have risen substantially to 14% and 43%, respectively—driven in large part by the emergence of China on the global stage (China joined the World Trade Organization in December 2001). With their share of global GDP second only to the United States ($20.9 trillion in the US versus $14.7 trillion in China), it may surprise some to learn that despite staggering economic growth their equity market return over the same period is similar to that observed in developed markets. As the largest emerging market, their share in EM indices has also risen substantially—from 3% to 39%. Looking ahead, and perhaps past the 2021 recovery, global GDP growth forecasts are expected to be led by continued growth in emerging economies—particularly those in emerging and developing Asia. With this backdrop, we believe emerging economies offer compelling prospects in the long term and have allocated risk accordingly in our portfolios. One need only to look at post-war Japan, Hong Kong or South Korea to make the investment case. Indeed, since the 1960s emerging economies have outperformed developed markets by around 1.5% per year, albeit with higher volatility.
As we emerge from a global pandemic, at different rates and with different country-specific risks, we believe a globally diversified portfolio is of special importance—one which allocates to both developed and emerging markets. The added diversification benefits and potential for superior returns underlie our investment thesis. It’s worth noting that exposure isn’t (and shouldn’t) be driven by where a company is headquartered or listed, as many global companies do have large exposures to the emerging world while benefitting from developed market governance structures. Furthermore, one cannot ignore the risks inherent in emerging markets—namely FX risk, poorer corporate governance and political risk, to name a few—which further makes the case for active management in these regions. Ultimately, we seek to allocate to best-in-class companies which will continue to compound at high rates over the long term, regardless of where they are located.
 Russell FTSE All-World Index
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