Home bias, or the tendency for investors to hold much larger positions in their home markets than modern portfolio theory would favour, is a feature that has been observed globally for a significant period of time. A Google search on ‘equity home bias,’ for example, returns an impressive 75 million results. A search for ‘bond home bias’ returns a smaller, but equally impressive, 41 million results. This wealth of theoretical and empirical work seems to imply that the merits and motives of home bias remain an enigma. However, the data clearly suggests that ‘home bias’ has been detrimental for UK investors for over a decade. Furthermore, the solution to this may not exclusively be found in international equities. Alternative assets are becoming a vital part of a modern portfolio, yet it’s an asset class that most investors fail to take advantage of.
To narrow down the discussion to a manageable set, we will focus on institutional or pension fund assets in the OECD and equities as the asset classes of interest. A recent paper[1] puts these assets at $32 trillion in total, with 90% of those assets concentrated in just seven countries[2]. For several countries, including the UK, the size of pension fund assets is larger than the GDP of the home nation and impacts the lives of millions. Given this footprint, it is not too surprising to find a rich dataset on these holdings and trends within them.
The largest investments that institutional investors make are, and have been for many years, in equity markets. [3] Despite a decline in average allocations over time for the top seven OECD nations, equity investments still constitute an average of 40% of total portfolio exposure. When you compare domestic equity holdings to their ‘neutral’ weight in the global equity market, the scale of the home bias effect is very apparent. [4] Australia has the largest bias to the local stock market, with pension fund equity holdings approximately 26x Australia’s weight in the world equity indices. The USA, perhaps unsurprisingly given the size of the market and the choices available, has the smallest home bias. The average American pension fund holds only 1.2x the weight of the USA in global stock indices. The UK comes in at 6x its theoretical ‘neutral’ weight. The wider one looks, the more prevalent this phenomenon is, with European pension funds domestic exposure ranging from 18x (Germany) to an eye watering 67x (Spain). We have been unable to find any evidence of a developed market pension fund not exhibiting home bias in their equity allocation.
What causes home bias?
Almost as widespread as the literature detailing this phenomenon is the literature trying to explain why it is present at all. There are a wide variety of reasons suggested, reflecting the practical reality of running a portfolio to more human, behavioural drivers. On the practical side, additional transaction costs, risks on governance and politics, currency risk and informational asymmetry are the most common reasons cited for not having a larger exposure to foreign equities. The very real need for a fund to match its domestic liabilities and assets to better correlate with local inflation is another of the commonly cited reasons for this bias to exist.
However, some of these explanations are a little old fashioned. Non-domestic equities may have been hard to understand, expensive to invest in and difficult to access in the past. In today’s world, though, where teenagers are investing in crypto currencies using their phones, it seems scarcely credible for sophisticated institutions to argue these barriers to entry remain significant. Globalization has impacted the investment industry as much as any other. The availability of low-cost passive options and similarly low-cost investment research, has made the investment world much more accessible and easier to understand than it ever has been.
