By Jackson Lee, CFA – Associate Quantitative Portfolio Manager, CLS Investments
My wife and I were doing our grocery shopping at Costco recently, and while we were browsing the snack section, she spotted some pistachios. For anyone who has snacked on pistachios before, you probably know that they are far more expensive than many other nuts, such as almonds or peanuts. But as I reached for the house brand to save a few dollars, my wife stopped me and said she wanted to go with the more popular brand, even though it cost almost twice as much! Fortunately, Costco was offering some samples of the house brand that day, and after trying a few, my wife was persuaded.
I’m sure we can all relate to this classic consumer/domestic battle, and I must admit, I am also guilty of this irrational behavior. Humans tend to choose the product they know and are often willing to pay a premium for it, even when it’s identical to a cheaper brand. This irrational behavior can also be seen in investing. Investors like to stick with the stocks they know, and this often means investors are confined by a home-country bias.
The average U.S. investor has about 75-85% allocated to domestic equities. But U.S. equities only account for about 50% of global market-cap. It used to be that the lack of information and access created barriers that restricted the average investor’s ability to own foreign stocks. However, the landscape of investing has changed thanks to technological advancements and the creation of ETFs. Information costs have gone down dramatically, and owning and trading foreign equities through low-cost ETFs has become a lot more affordable.
If you think home-country bias is isolated to retail investors, think again. A recent study we conducted at CLS reviewed the average international allocations in the mutual fund and ETF universe to gauge whether professional money managers are also exposed to home country biases. The result was shocking. Just like average investors, money managers typically allocate only about 25% of equities to international markets. In addition, the ebbs and flows of international allocation point to performance chasing, as evidenced by the graph below.
Considering the outperformance of U.S. equities since the 2008 financial crisis, it is easy to forget the benefits of global diversification:
1. Performance of the U.S. market and international markets tends to be cyclical in nature. The current cycle length of U.S. outperformance is the longest it has been since 1970 and is almost double the historic average of 70 months.
2. Valuations of U.S. equities relative to international are extremely high. Despite the recent drawback at the end of 2018, current relative valuations are still well above the historical average (two standard deviation points higher). While valuations may deviate from the mean in the short term, mean reversion is bound to happen over time.
3. Based on the diversification benefits, we believe it’s always a good time to invest in international. Much research, like the chart below from Vanguard, has shown that the risk-reduction benefits of global diversification continue to grow until approximately 70% of the portfolio is allocated to international investments
While investors may have gotten away with a home-country bias over the past decade, it is a good time to reconsider those allocations. The current valuations and outlook suggest that international should have a higher expected return going forward. Of course, the U.S. market could continue to outperform, but history suggests the chances are slim. And, while I may occasionally give in on brand-name shopping to keep the peace at home, I’m not willing to give up the long-term benefits of a global portfolio.
Jackson Lee is Associate Quantitative Portfolio Manager at CLS Investments, a participant in the ETF Strategist Channel.
95-CLS-1/28/2019