Investment Research & Insights for UK Financial Advisers

Home equity bias is irrational and has penalised UK investors

15/7/2020

Why does home equity bias exist?
What does the research say?
What does recent experience show?

Traditionally, UK pension fund managers and UK private client managers alike would have a bias towards home (i.e. UK) equities. Why is this, what does the research say and what does recent experience show?

Understanding “home bias”
First of all, what do we mean by home bias? We define home bias is allocating substantially more to the investor’s “home” market, relative to its capitalisation-based weight in a global equity index. Given the UK’s weight in global (developed markets + emerging markets) equity indices is now approximately 4% (it has been on a steady drift lower), any allocation above that level can be considered a home bias, from a UK investor’s perspective.

Yet traditionally UK pension schemes and private client managers would split an equity allocation between broadly 50% UK and 50% international (ex-UK) equities. This represents a massive home equity bias, with a UK weight that is over 10x its market-cap based weight.

Why does this home bias exist?
The reasons given for such a massive home bias are typically the following:

From a currency-matching perspective, managers want sterling exposure for good chunk of their equities as investors’ base currency is sterling
The largest UK equities are “global” in nature, hence a share in, say Diageo plc represents revenues from all around the world
Managers have access to management and can greater insight as regards home companies

We can look at each of these in turn.

Firstly, we would argue that investing in equities is not for currency/liability matching, but for return seeking and inflation beating: in which case, the broader the opportunity set, the greater the potential for returns.

Put differently, a UK only investor is not only wilfully or accidentally ignoring 96% of the opportunities available in equities, by value, but would also thereby miss out almost entirely on the technology revolution led by US companies, for example, or the demographic revolutions of emerging markets.

So whilst a home bias makes sense for a bond portfolio (matching changes in inflation and interest rates), a home bias for equities does not.

Secondly, whilst the largest UK companies within the FTSE 100 are indeed “global” in nature, the broader, and more diversified (by sector and constituents), all share index is not. Furthermore the sector allocation of the UK market is skewed by domestic giants, can be out of step with the sector allocation for world equity markets.

A UK equity bias is therefore a structural bias towards Consumer Staples, Materials and Energy, and a structural bias against Information Technology.

Fig. 1. Sector Comparison UK Equities relative to World Equities

Thirdly, whilst it is indeed true that UK managers will be able to get more access and insight to UK companies than, say, an overseas-based manager, for portfolio managers who focus on asset allocation over security selection, this access to management is less relevant and less valuable.

Whilst we can debate the detail of all three of these arguments, they are not individually or together enough to justify an allocation to UK equities that is over 10 times its market weight. This is not a question of a rational overweight, it’s simply an irrational bias.

What does the research say?
There has been extensive research into why individual investors and professional managers have a preference for creating an equity portfolio with a strong home bias[1].

French & Porterba (1991) observed the predominantly home equity bias of investors based on the domestic ownership shares (as at 1989) of the largest stock markets. In each case the high domestic ownership of each respective market implies a high home equity bias at that time: US (92.2%), Japan (95.7%), and the UK (92%), for example. In 1990 UK pension funds held 21% of their equity allocation in international equities from just 6% in 1979 (Howell & Cozzini 1990). Now the figure could be closer to 50%, or even higher. The shift away from home equity bias has been steady and pronounced in the UK institutional market, but is still ingrained.

However, it’s worth noting that subsequent home bias research is written in the US. Given the US represents approximately 66% of the world equity market (a share that has been steadily increasing), the central tenet of that research is that home-biased US managers miss out on the diversification benefits and increased opportunity set available from investing in markets outside the US. Hence home-bias for a US manager creates a smaller “skew” vs Global Equities than it does for a UK manager.

What is current practice?
Whilst the institutional UK managers have been gradually reducing home bias within equity allocations, what about UK retail portfolio managers?

We looked at the MSCI PIMFA Private Investor Indices[2] – and predecessor indices – to gain an insight as to what current asset allocation practice looks like for UK-based managers in the retail market. These weightings of these indices are “determined by the PIMFA Private Indices Committee, which is responsible for regularly surveying PIMFA members and reflecting in each index the industry’s collective view for each strategy objective”[3].

Based on the “Balanced” index (and predecessor indices[4]), within a typical balanced mandate, the allocation within the allocation equities have decreased from a 70/30 UK/international split in 2000, to a 48/52 split today (see Fig.2.). Whilst this reflects a reduction in the home equity bias, it is nonetheless a material bias towards UK equities by retail investment managers.

Fig.2. UK/international equity split within an indicative UK retail balanced mandate

Source: Elston research, FTSE data, MSCI data
In fairness, PIMFA has responded to this through the creation of a “Global Growth” index, which is 90% allocated to developed markets, and 10% allocated to emerging markets – so no UK home bias at all: but this is also a different risk profile to the Growth Index (100% equities, rather than 77.5% equities).

Zimbabwean investors go global – UK investors should too
We would make the case to advisers that if you were advising someone who lived in Zimbabwe, gut instinct would suggest that having the bulk of their equity allocation in Zimbabwean equities would feel like a poor and restrictive recommendation. After all, Zimbabwe makes up only a fraction of the global equity market.

Without wanting to do UK plc down, the same gut instinct should apply to UK equities. If the UK is only 4% of global equities – why allocate much more than that?
If you believe in equities for growth, it follows you believe in global equities to access that growth. Clients benefit from being shareholders in the changing mix of the world’s best and largest companies, not just the local champions.

What does recent experience showing
This debate was largely confined to theory given the relative stability of GBP to USD prior to Brexit. But given the dramatic currency weakness on the Brexit referendum, and the UK’s lack of exposure to the technology “winners” from the COVID-19 crisis, the disconnect between UK and Global Equity performance could not be more acute.

Over the 5 years to 30th June, the FTSE All Share has delivered an annualised return of +2.87%p.a. in GBP terms, and MSCI World has delivered +7.53%p.a. in USD terms. That represents the difference in the performance of the underlying securities within those markets. Adjusting for currency effect too, and MSCI World has delivered +12.79%p.a. in GBP terms: an approximately 10ppt outperformance annually for 5 years.
When expressed, in cumulative terms, the disconnect is more clear: over the 5 years to 30th June, the FTSE All Share has returned +15.22% in GBP terms, and MSCI World has delivered +43.80% in USD terms, and +82.66% in GBP terms: a 67.44% cumulative performance difference between those indexes, and the ETFs that track them.

Fig.3. World vs UK Equity performance, 5Y to June 2020, GBP terms

Source: FTSE All Share, MSCI World, Bloomberg data
Delivering good portfolio returns is less about picking individual winners within each stock market, but making sure you have access to the right asset classes for the right reasons. Index funds and ETFs are a low-cost, liquid and transparent way of accessing those asset classes.
UK multi-asset perspective
From a multi-asset perspective, the performance difference between MSCI PIMFA Global Growth (100% equity, no home bias), MSCI PIMFA Growth (77.5% equity, with home bias) and other risk profiles is presented in Fig.4. below.

Fig.4. MSCI PIMFA Private Investor Index Performance, 5Y to June 2020, GBP terms

Source: MSCI PIMFA Private Investor Indices (formerly WMA), Bloomberg data
The choice whether to embrace a UK home bias or avoid it has been critical and material and the main determinant of differences between multi-asset portfolio and multi-asset fund performance.

The lack of UK home equity bias, is one of the key underpins of strong performance of the popular HSBC Global Strategy Portfolios and Vanguard LifeStrategy range, for example.

A question of design
Our preference for avoiding entirely any UK home bias for equities (but not for bonds) underpinned the construct of multi-asset funds and multi-asset portfolios that we have developed with and for asset managers. End investors in those products have benefitted from that key design parameter.

Whilst we welcome managers launching global-bias multi-asset portfolios – it’s a bit late in the day as it won’t help their existing clients stuck in UK equities claw back the foregone performance of the last 5 years.

The irony is that one of the reasons for the persistence of home equity bias is sustained by asset allocation providers used by wealth managers to construct multi-asset funds and portfolios. A closer interrogation of those research firms’ methodologies, parameters and constraints is required to think what makes best sense for end investors.

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Notes
[1] French, Kenneth; Poterba, James (1991). "Investor Diversification and International Equity Markets". American Economic Review. 81 (2): 222–226. JSTOR 2006858

[2] https://www.pimfa.co.uk/indices/

[3] https://www.pimfa.co.uk/about-us/pimfa-committees/private-investor-indices-committee/

[4] We define the predecessor indices to the MSCI PIMFA Private Investor Indices as: MSCI WMA Private Investor Indices, FTSE WMA Private Investor Indices, FTSE APCIMS Private Investor Indices

Notices
Image credit: Lunar Dragoon
Commercial interest: Elston Consulting is a research and index provider promoting multi-asset research portfolios and indices. For more information see www.elstonetf.com

Ashley Reid

10/8/2020 13:01:00

Hi Henry, please see below a few thoughts on your recent paper.
Kind regards
Ashley

The objective of any investor should be to maximise the available opportunity set so as to maximise the potential to generate superior returns.
Whilst this may be subject to a number of considerations, (for example ethical, liquidity, income, risk tolerance or the ability to research efficiently) this should be the starting point.

Your argument is aligned with this premise. A high allocation to UK has not served investors well for a number of years. There are a number of reasons for this, for example relative sector and style biases of the UK market. There may also be a specific Brexit factor which has imposed a relative discount on the valuation of companies exposed to the UK economy, although the overall impact on index performance is open to debate.

But even if it does make investment sense, making the shift and trying to think globally rather than just across the UK equity market provides multiple levels of complexity and can be a daunting task.
So there are a number of key questions investors with a heavy allocation to UK listed equities need to address before repositioning their portfolios.
These include the following;

Is it the right time now?
Timing is notoriously difficult, and more luck than judgement. A wholesale shift now would lock in past underperformance without guaranteeing better future returns.

Should a global passive versus active approach be adopted?
A global passive allocation itself contains biases. It currently provides approximately a 60% allocation to US equities, which have outperformed strongly in the last few years due in no small part to a different sector weight structure, and as a result, different style biases.
Switching now would lock-in this good performance without the benefits being enjoyed, and replace one dominant country allocation the UK, with another, the US.

If not what should the allocation framework be?
Investors need to properly consider the underlying country, sector, style and macro risk factors they will be exposed to, regardless of the approach they adopt. As noted above, the US market dynamic is a clear example of why this needs to be monitored.

How should investors used to stock picking, consider the much wider global opportunity set?
The MSCI All Country World Index for example consists of large and mid-cap stocks across 23 developed and 26 emerging markets covering more than 3,000 constituents. A bottom-up stock picking approach in this universe is no small undertaking.

How should investor specific requirements be addressed?
For a number of reasons any specific investor considerations, such as ESG factors, tax, income or the practicalities of lot size may also be more challenging to manage when considered across multiple investment regimes.

These are not easy questions to answer, and are just a few of the considerations which are beyond the scope of this reply. But get them wrong, and an investor making the switch could compound the error of their previous positioning.
The argument for reducing a reliance on the UK equity market is not a short term timing issue, nor to jump on performance a trend, but is critical to ensure the medium to long-term opportunity set is as wide as possible.
And even if a switch to a passive allocation is made, it’s not a passive decision. There’s no such thing in the world of investment. Investors need to be aware that a global passive allocation itself contains biases in terms of style, sector and geographic exposures which inherently represent risk exposures and is an active decision to accept what “the market” is offering today.

So investors should adopt a measured approach, remaining aware of the timing risk.
They need to be clear of their investment objectives, the implications of the decision to invest actively or passively, and the array of risk factors they will be exposed to.

As a final point, note that a US equity investor, 100% invested in their local market would currently have a very different view on the local vs. global argument. They have done very well in the last few years by maintaining a domestic bias, again due to sector and style biases.
But a note of caution, as such strong performance from the US has not always been the case. There have been extended periods when non-US (EAFE) has performed much better such that US investors were faced with the same questions UK investors are faced with now.
If there is a lesson here, it’s for investors to focus less on where a company is listed or how an investment product is structured, but more on what underlying risk exposures they provide and the resultant scenario dependencies.

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Asset Allocation Research for UK Advisers

Home equity bias is irrational and has penalised UK investors

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