Brexit reminds us of home bias risks

29 September 2016

Jason Baran – Insight Analyst, Insight and Consulting: Funds and DFM

The Brexit result at the end of June created some initial high volatility across many international markets and in the UK itself. While most investment markets have settled down for now, and UK equities are near their highs, the pound has fallen about 10% against most major currencies.

Had a UK-based investor diversified in overseas assets they could have protected themselves much better against this volatility and would be seeing greater returns post-Brexit vote. However, when we look at real portfolios as constructed by investors, fund managers or DFMs, we frequently see higher weights to the UK than might be expected, especially if we compare the size of the UK market by capitalisation vs other international markets (whether it be equity or fixed income).

In an age of increasingly sophisticated portfolio optimisation tools and greater understanding of volatility we have to wonder why this home bias exists. Diversification is frequently refered to the one ‘free lunch’ available within investing – why let it go to waste?

There are several reasons that have been suggested for home bias, some of these are behavioural while others may have more logical backing:

  • Keeping to what is familiar

Investors may feel they are more knowedgable or comfortable about companies or investments closest to home. However, there have been several studies that have shown investors to be overly optimistic about home-country investments to the detriment of long-term returns

  • Multinational companies

Investors may judge that because their home market is composed of companies involved heavily in international trade, they are in fact gaining international diversification

  • FX effects

Investors may perceive that FX risk and fluctuations make investing overseas undesirable

  • Corporate Governance

There is a view that corporate governance (reporting, transparency, shareholder rights) is stronger in more mature home markets and hence overseas emerging markets should avoided

  • Overseas transaction costs

Brokerage, admin fees or transaction fees may be higher for overseas investing and could act as a deterent

  • Giving the market what it wants

Fund managers mention they run UK focused portfolios primarily because that’s what clients ask for, even if they themselves believe better investment opportunities lie elsewhere

 

Looking at data we have available from DFMs at Defaqto, the average MPS has a 50% allocation to the UK, comprised across both equity and fixed income. On the otherhand, our Defaqto fund insight team  also create optimised risk/return benchmarks across all of our risk profiles, using the Moody's risk model to simulate future asset class returns. These benchmarks have only a 20% allocation to the UK on average. Hence the overall impression is given that UK based DFMs do indeed overweight the UK within their portfolios.

As the experience of the Brexit vote shows, diversifying overseas can help achieve returns with lower risk than investing in the UK alone. While there are some sound reasons to overweight a portfolio to the UK, investors should question if they are being swayed by fear of the unknown or are keeping to what seems familiar. These investors could end up with lower returns in the long-term.

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