Investors need to be aware of stock concentration implications

A continuing feature of strategic asset allocation in Australian portfolios is a relatively high weighting towards domestic assets — a phenomenon known as ‘home country bias’.

When looking at this bias experience closer and in the context of the international experience, it is clear that Australia is not unique. In fact, home bias in asset holdings is one of the least disputed empirical findings in global finance. And whilst modern portfolio theory predicts that investors should diversify, the fact is that local investors have a clear preference for investing in local assets.

It is not until you begin to measure the mix of domestic versus international assets relative to the truly global investment set that you start to realise the striking imbalance between home assets and home capitalisation. For Australia, circa 40 per cent of equity assets are invested domestically, whilst Australia’s market capitalisation relative to the global opportunity set is only 2.5 per cent. Countries including Belgium, Spain, Canada, the Netherlands, the UK and Japan are little better, if at all, with the US the only market showing some signs of balance.

Philosophical vs analytical arguments

There are two broad arguments used to explain the home country phenomenon — the philosophical and the analytical. Perhaps the most stirring philosophical argument is that which suggests we should be investing our assets where our liabilities exist. This is a simple, intuitive argument founded on the basis that growth asset investments will maintain a value of purchasing power parity against your liabilities adjusted for inflation in Australian dollars, and that growth in the domestic economy will outpace inflation.

However, looking at the philosophical proposition of asset liability matching, on further analysis, the intuitive proposition does create some doubt. Whilst our consumption is in Australian dollars, the goods we consume are not Australian dollar originated: toothpaste (Colgate), cars (Toyota), petrol (Shell), light bulbs (Philips), electronics (Sony), and the list goes on. This easily draws the question, “Why not invest in the profits that we help create in the international market”? Equally, on closer analysis of the assets, 50-60 per cent of Australian stocks have assets or earnings outside Australia, and 30-40 per cent of the market capitalisation has production and/or earnings sourced offshore. Together the asset liability matching analysis does raise some questions.

Many additional philosophical arguments centre on the notion that as domestic investors we have a greater understanding — and therefore a greater ability — to assess the environment in which we are operating. This includes factors such as the ability to interface with local management, a greater understanding of the regulatory environment, and access to taxation benefits not available to us overseas. As domestic investors we do have the ability to influence the outcomes, the structure, and the direction of companies.

Add to this the important factor of ‘defendability’ — which is based on the idea that in falling markets (as trustees and owners of the investment decision) it is easier to defend an overweight domestic position than an overweight international position — then on face value a very plausible philosophical argument exists.

Possibly more convincing are the analytical arguments surrounding home country bias. In the past 10 years we have seen a significant change in market return and correlation behaviour.

By comparing domestic and international 10-year risk/return figures to June 1995 and June 2005 we can see that, in the case of both domestic and international unhedged equities, there has been a significant reduction in risk.

Most significantly, in Australia, this massive reduction in risk has not been detrimental to overall returns, whereas international unhedged equity returns — while still returning a positive outcome — have been negatively impacted. Over the same period there has been a reduction in the overall returns produced by international hedged equities and this has been achieved with a higher level of risk. We can conclude, therefore, that international equities have not delivered what financial theory would suggest that they should have.

Equally, when you optimise these and look at the mix of equity assets in a balanced portfolio, based on the 10-year risk return, in June 1995, a blend of 40 per cent domestic equities and 60 per cent international equities would have provided an optimal asset mix in terms of return and risk.

However, in June 2005, the efficient curve starts to look much different with a blend of 60 per cent domestic equities and 40 per cent international equities providing an optimal outcome. Based on this approach, at its most basic level, international diversification has not benefited portfolio performance.

Local limitations

When looking at Australian equities it is valuable to understand what you are actually getting. At A$770bn, it represents less than 3 per cent of the global opportunities. Thirty-five per cent of the market capitalisation is in the financial sector — 23 per cent higher than the international environment — and a large investment relative to the contribution the financial sector makes to Australian GDP (circa 10 per cent). This is largely a function of the privatisations and demutualisations in this sector over the last 5-10 years. Whilst the ASX is diversified within itself across all the sectors relative to the international environments, it is heavily tilted to financials and materials, and light on IT, healthcare and energy. Does this account for the Australian equity market’s strong relative performance over the last 5-10 year period? More significantly, will it into the future? A question we all ask!

So, it is prudent to be aware of sector importance and the stock concentration that comes from it. With ongoing merger and acquisition activity both domestically and internationally, we need to be aware of the stock concentration effect and the impact of this on overall risk management within an investment portfolio.

Home bias in investment portfolios is a real but diminishing phenomenon. The reduction of home bias will be a gradual response to economic and market factors, and consumer and investment behaviour. A change in convention and in the way in which money is managed should result in investments being less sensitive to location. Globalisation will be a continuing theme and sectors will increase in importance from a diversification risk management perspective. Global investment management platforms will become increasingly important, as the structure of the Australian equity market makes it fundamental for investment managers to have global platforms in order to undertake effective analysis of the revenue, assets, competitive structure, management, and strategies of the companies we invest in.

David McClatchy is chief investment officer, ING Investment Management.