Being overweight domestic equities can be a problem
With TSX returns down more than 7% so far this year, now is a good time to remind clients to venture beyond Canada when investing—and there are several other convincing reasons to do so.
“On average, a Canadian maintains roughly half their total equity exposure within Canadian equities, which themselves only make up around 3% of the total world equity benchmark,” said Slava Kulesh, senior research analyst, investment management research at CIBC, in an interview earlier this month.
“In effect, Canadians are 47% overweight their home markets.”
Only Australians are worse positioned, he added, at 58% overweight domestic markets.
Home-country bias isn’t, however, the sole domain of far-flung former British colonies.
“It’s a people problem rooted in our primordial pull for the familiar that dates back tens of thousands of years ago to our hunter-and-gatherer days where familiarity was synonymous with safety,” said Kulesh.
Behavioural psychologists have found that, given two options, people tend to prefer the one with which they’re most familiar, he said.
“We shouldn’t be surprised that, when a Canadian is faced with a portfolio full of Bells, Rogers, TDs, CIBCs [and] Scotias, and one full of European and Japanese financials and telecoms, they prefer the Canadian portfolio because they feel more comfortable with it,” said Kulesh.
Leave your comfort zone
Choosing comfort can come at a cost.
“The average Canadian is taking on too much commodity, sector and stock-specific risk without being properly compensated for it,” said Kulesh.
For example, Canadian equities have “drastically” underperformed other major indexes on a risk-adjusted basis over the last decade, he explained. That’s because emerging market growth reached a pinnacle of 8.5% in 2007 and has since moderated, and commodities demand likewise decreased.
Further, over the same period, the market began rewarding innovation. That’s been a challenge for the TSX, with its 4% sector weight in information technology and 6% weight in consumer discretionary, he said.
If the pace of innovation continues and there isn’t another commodities boom, said Kulesh, “a global basket of equities that can benefit from a variety of regions, industries [and] return drivers is more prudent than betting on one market for the long term.”
In addition, the top three sectors in the TSX—financials, energy and industrials—make up almost two-thirds of the index and are highly correlated. For example, a drop in oil prices can drag down financials, as energy companies are a meaningful portion of banks’ lending books.
In comparison, the top three sectors in the global equity index MSCI ACWI—information technology, financials and consumer discretionary—comprise about half that index.
The stock mix of the TSX offers no reprieve: the index’s top 10 holdings make up more than one-third of the index, said Kulesh, and these companies earn revenues largely within Canada. In fact, the top three names—Royal Bank, TD and Scotiabank—earned on average more than 60% of their revenues in Canada last year, he said.
In contrast, the S&P 500’s top three names—Apple, Microsoft and Amazon—earned less than 50% of their revenues domestically, leading to more diversified earnings and positioning.
Those revenue figures are even more “staggering,” said Kulesh, considering the U.S. makes up almost one-quarter of world GDP, while Canada makes up a mere 2%. You’d expect domestic companies to tap into other markets for growth.
Don’t put your eggs in one basket
If his domestic-market risk analysis fails to convince investors to diversify their holdings, Kulesh makes a further point: investors’ human capital—the value of future income yet to be earned—adds to the risk of home-country bias.
Consider an oil worker with a large position in Canadian equities. After 2014’s collapse in oil prices, the worker might have lost not only his job but also significant portfolio returns.
The oil worker’s “holistic financial well-being would have been threatened,” said Kulesh. “And if this occurred close enough to retirement where [he] couldn’t earn back or supplement lost wages, and their portfolio didn’t have time to rebound, the consequences could be dire.”
Kulesh can relate, given the wealth industry can also be affected by market and economic dips. “As someone who works in asset management, I too face a similar risk come an economic downturn,” says Kulesh, as would a manager of a clothing retailer.
“Unless you are a teacher, doctor, nurse or […] government worker, chances are the industry in which you are employed ebbs and flows with Canada’s economy.”
Economic ebb and flow provides yet another reason to allocate equities to international markets: while the TSX is highly correlated with Canada’s GDP, other stock markets aren’t.
“The pronounced movement towards globalization in the last couple of decades may leave some surprised to learn that there is no statistically significant correlation between Canada’s GDP and stock markets outside of North America,” says Kulesh in a paper he co-authored on home-country bias.
He suggests advisors discuss with clients the importance of diversification and assessing their current and future finances. By cautioning against the potential impact of home-country bias, advisors will properly address “their clients’ primordial pull for the familiar that’s not going to go away,” he said.
The report also includes tips on taxes and dealing with currency fluctuations.
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.