Investment Insights Home Country Bias: Determining the ...Investment Insights Home Country Bias:...

Investment Insights

Home Country Bias: Determining the Right Split

between Canadian and Foreign Equities The term “home country bias” describes the tendency of investors to have a disproportionately

large portion of their portfolios allocated to domestic equities. In Canada, for example, although

our domestic equities make up only 3% of global equity markets,1 many institutional investors

have 30–50% of their equity portfolios allocated to this asset class.2

Although Canadian pension plans

significantly increased their allocations to

foreign investments following the relaxation

and ultimate elimination of the foreign

property rule in 2005,3 the tendency towards

home country bias persists. Allocations to

foreign equities rose, on average, from half of

total equity exposure in 2005 to more than

two-thirds in 2015,4 and allocations to other

types of assets outside of Canada have also

grown. The largest Canadian pension plans as

well as smaller and mid-sized institutional

investors have been moving in this direction.

The purpose of this paper is to help investors determine an appropriate split between domestic

and foreign equity exposure for their portfolio. While there is no one right answer to this

question, we discuss some of the factors that investors should consider while making this

decision, including risk and return expectations. We consider foreign developed markets and

emerging markets separately, as the arguments for including them in portfolios are somewhat

different. We also consider the shifting equity allocations of other institutional investors in

Canada in order to provide a comprehensive perspective on industry trends.

1 Canada’s percentage of the MSCI All Country World Index as at December 31, 2015.

2 Greenwich Associates, The Canadian Institutional Investors 2015.

3 Prior to 2005, regulation limited the extent to which Canadian domiciled portfolios could invest outside of Canada.

4 Greenwich Associates, The Canadian Institutional Investors 2015.

Phillips, Hager & North Investment Management 2

Home Country Bias: Determining the Right Split between Canadian and Foreign Equities

The Impact of Foreign Equities on Portfolio Risk

One significant argument for Canadian investors to include non-Canadian stocks in their

portfolio is the expectation that they will reduce risk compared to a portfolio made up of entirely

Canadian equities. There are three primary reasons for this:

Foreign developed market equities tend to be less volatile than Canadian equities. As

shown in Figure 2, the volatility (annualized standard deviation of monthly returns) of the

Canadian equity market has been on average 21% higher than that of the global equity

market over the past 46 years, at 16.2% compared to 13.3%.

This higher volatility is

largely due to the fact

that the Canadian equity

market (as measured by

the S&P/TSX Capped

Composite Index) is

more concentrated,

containing between 200–

300 stocks, compared to

the broad global equity

market (as measured by

the MSCI World Index),

which contains

approximately 1,600 stocks. Furthermore, the Canadian market is dominated by the

Financials, Energy, and Materials sectors, of which the latter two in particular tend to be

more volatile by nature. In addition, the S&P/TSX Capped Composite Index has very little

exposure to the Health Care, Information Technology, and Consumer Staples sectors and the

diversification that they bring.

In contrast, lower volatility is not an argument for emerging market (EM) equities. Although

the volatility of these markets has declined over the past 28 years, they continue to have a

higher risk profile than their developed market counterparts and remain considerably more

volatile as a result.

Diversification. Correlation is a measure of the tendency of two assets to move in tandem: a

correlation of 1 indicates the assets are perfectly synchronized, whereas a correlation of 0

indicates there is no relationship between their two movements. While in general Canadian

and global equities will move up and down at similar times, their movements are not

perfectly synchronized. As shown in Figure 3 on the following page, the average correlation

between Canadian and global equities over the past 46 years has been 0.66, indicating a

diversification benefit from adding global equities to the equity mix.



The average correlation

between Canadian and

EM equities has been

0.69 over the past 28

years and has increased

as EM countries and

capital markets have

become more integrated

globally. Nevertheless,

EM equities still provide

a diversification benefit,

and this diversification

benefit may actually

increase going forward as the weighting of natural resource stocks, which tend to be highly

correlated globally, has decreased in both Canada and EM countries, particularly the latter.

Currency impact. While introducing global equities to a Canadian portfolio introduces

exchange rate risk, historically this has actually reduced the risk of the overall portfolio. This

is because during periods of global equity market weakness, the Canadian dollar typically

weakens relative to the U.S. dollar and other major currencies. Thus, a relatively weak

Canadian dollar acts as a

shock absorber and has

the effect of offsetting

the losses incurred by a

global equity portfolio, as

shown in Figure 4. For a

discussion of why this

occurs and whether it

should be expected to

continue, please see “The

Canadian Dollar as a

Natural Investment

Hedge” in the Appendix.

The Impact of Foreign Equities on Returns

While reducing risk is a key argument for incorporating foreign equities in a portfolio, expected

returns are also an important consideration. The following sections examine the long-term return

expectations associated with both global developed and emerging markets compared to the

Canadian equity market.



Global Equities

In setting investment policy, institutions and their consultants often make the simplifying

assumption that Canadian and global developed market equities are likely to generate similar

returns. This assumption is broadly consistent with the historical evidence: Over the past 46

years, annualized returns on the global developed equity market have been 9.2%, compared to

9.0% on the Canadian market.5

There is, however, an important caveat: Canadian and global developed market returns are likely

to deviate significantly from these assumptions for long periods at a time. This divergent relative

performance can be caused by relative economic performance, currency performance, the sector

makeup of the markets, fund flows, or other factors that can be very difficult to predict.

These periods of divergent relative performance are illustrated in Figure 5. As shown below,

over the past 45 years the Canadian market has gone through two extended periods of

outperformance relative to global developed market equities, with one 19-year period of

underperformance in between. The 10-year period of strong outperformance from 1998–2008

was due in large part to Canada’s large exposure to natural resource companies and driven by

growing demand for commodities from China.

More recently, however,

because the Canadian market

has relatively little exposure

to the Information

Technology, Health Care,

and Consumer Staples

sectors, it has

underperformed as

commodity prices have

declined and these other

sectors have fared better.

While the causes of these

periods of relative

performance are easy to understand in hindsight, they are very difficult to predict in advance. As

a result, although Canadian and global developed markets have generated similar returns over the

past 46 years and it is reasonable to assume they will continue to do so in the future, investors

should understand that there will be periods of considerable divergence. For this reason, while

over the long term we might expect similar returns from Canadian and global developed markets,

an allocation to each can help a portfolio realize its expected returns in a more stable way over

shorter-term as well as longer-term investment horizons.

5 Total returns in Canadian dollars. Global equities are represented by the MSCI World (Net) Index, Canadian

equities are represented by the S&P/TSX Capped Composite Index. Sourced from Bloomberg.



Emerging Market Equities

In setting investment policy regarding EM equities, institutions and their consultants will

normally assume that this asset class will generate higher returns than Canadian equities. This

assumption, too, is broadly consistent with the historical evidence: Annualized returns on the EM

equity market over the past 28 years have been 9.3%, compared to 7.9% for the Canadian

market.6

This assumption is further informed by a number of factors, most prominently: a view that EM

economies are likely to grow faster than developed economies for the next decade or more, the

premise that higher returns represent a risk premium to compensate investors for the higher risk

inherent in EM equities, and because there is more potential for value-added from active

management in emerging markets.

That said, as with Canadian and global developed markets, the returns of the Canadian equity

market relative to its EM counterpart are also likely to deviate significantly from these

assumptions for long periods at a time.

These periods of divergent

relative performance are

illustrated in Figure 6.

Over the past 28 years

there has been one 7-year

period of sharp EM

outperformance, followed

by a 6-year period in

which Canadian markets

outperformed. More

recently, the two have

performed roughly in line

with each other, as both

markets have suffered

from the poor performance of natural resource stocks and currency weakness. The message

illustrated by Figure 6 is similar to the one conveyed in the previous figure: while EM equities

have generated higher relative returns in the past and should be expected to do so in the future,

they can experience long periods of divergence.

In summary, when setting long-term asset allocations we believe it’s reasonable to assume that

global and Canadian equities will have similar returns and that returns from EM equities will be

higher over the time horizon for which institutional investors typically set policy (ten years or

more), but accept that returns will vary considerably over shorter time periods.

6 Total returns in Canadian dollars. The time periods are not the same because data for emerging market equities

only starts in 1988. Canadian equities are represented by the S&P/TSX Capped Composite Index, and emerging

market equities are represented by the MSCI Emerging Market Index. Sourced from Bloomberg.



Putting Risk and Return Together – What’s the Optimal Mix?

Having made some assumptions about expected risk and return, investors then need to convert

these assumptions into asset allocations in a portfolio.

For this discussion we’ll use mean-variance analysis to determine the portfolios with the best

risk-adjusted returns as measured by the Sharpe ratio.7 For the purposes of these illustrations we

have held the fixed income allocations constant at 40%, and for the equity allocations we have

assumed volatility and correlation of returns consistent with history. Although we made the

simplifying assumption of doing this analysis in an asset-only context and do not delve into the

liability-relative context that is more relevant for some investors such as pension plans, the

conclusions are broadly similar.

Global Equities

Figure 7 illustrates the optimal mix of Canadian and global equities in a portfolio using a range

of relative return assumptions. The middle column shows the optimal split assuming that both

Canadian and global markets

will generate the same

expected returns, which is

consistent with historical

experience. Based on this

assumption, the portfolio

with the best expected risk-

adjusted returns has a 44%

allocation to global equities

and only a 16% allocation to

Canadian equities; in other

words, more than 73% of the

equity weighting is allocated

to global equities.

Recognizing that the future may differ from the past, Figure 7 also shows a range of relative

returns for Canadian and global equities. This sensitivity analysis varies the relative return by up

to 1.0% in either direction. The bar marked “-1.0%” provides the optimal portfolio under the

assumption that Canadian equities underperform global equities by 1.0% annually going

forward. Under this assumption, this modelling approach suggests investors should own very

little in the way of Canadian equities.

Looking to the other end of the chart, we can see that the only conditions under which the

modelling suggests making similar-sized allocations to Canadian and global equities are if an

investor expects Canadian equities to outperform global equities by 1.0% annually, to

7 The Sharpe ratio measures the return per unit of risk, and is defined as follows:

Sharpe Ratio = (Annualized Return – Risk-Free Rate of Return) / Annualized Standard Deviation of Monthly

Returns



compensate for their risk. Accordingly, investors that have half or more of their equity allocation

in Canada should ask themselves if this is consistent with their expectations.

Emerging Market Equities

We have taken a similar approach to modelling an optimal allocation to EM equities in Figure 8,

once again holding the fixed income allocation constant at 40% and assuming volatility and

correlation of returns consistent with history. We have also assumed that Canadian and global

developed market equities generate the same expected return. The middle column in Figure 8

shows the optimal equity

split under the assumption

that EM equities will

generate the same future

returns as Canadian and

global developed market

equities. Given the relatively

high volatility of EM

equities, it may come as a

surprise that the optimal

allocation to this asset class

is 7% – higher than most

portfolios’ allocations, and

higher than EM’s share of

the world’s equity markets. This large allocation is the result of EM’s lower correlation with

developed markets; these markets tend to move up and down at slightly different times.

As we move to the left on the chart, EM equities are assumed to have lower returns, and the

optimal allocation declines to zero. This is intuitive, as lower returns and higher volatility

overwhelm the diversification benefit of imperfect correlations. However, as we move to the

right, the results are more unexpected. If we assume that EM equities return just 1% more than

Canadian and global equities going forward – which is less than their historical return premium –

this modelling approach suggests putting 15% of the portfolio in EM equities. This is likely

higher than even the biggest allocations to EM equities in Canadian institutional portfolios today.

This analysis suggests that unless investors hold a pessimistic long-term view on EM equities,

they would be well served to consider a meaningful allocation to this asset class.

Perspectives – What Are Others Doing?

Canadian institutional investors of all sizes have been gradually increasing their exposure to

foreign equities over the past decade, to varying degrees and for varying reasons. In the

following section, we will examine the changing equity allocations of the country’s largest

pension plans as well as the evolving asset mixes of smaller and medium-sized institutions.



Large Canadian Pension Plans

Large Canadian pension plans have visibly increased their foreign equity allocations in the last

ten years. This is illustrated in Figure 9, which highlights the shifting equity allocations of three

large Canadian pension plans. This shift is partly due to the elimination of the foreign property

rule, which constrained the

ability of Canadian pension

plans to invest directly in

foreign public equities

(though the biggest plans

were able to circumvent the

rule through the use of

derivatives). However, it is

more broadly because many

large plans view foreign

equities as a beneficial and

desirable investment

opportunity set, and an

enhancement to their equity

portfolio.

Following the elimination of the foreign property rule, the Canada Pension Plan Investment

Board (CPPIB) summarized their motives for increasingly diversifying their holdings by

geography in their 2006 annual report. First, they were concerned that Canada’s market was too

small and too heavily concentrated in a few sectors while offering very limited opportunities to

invest in others. Second,

because the flow of

contributions into the CPP

Fund is closely tied to the

health of the Canadian

economy – a consideration

that is also relevant for many

Canadian pension plans –

global diversification offers a

source of returns when the

Canadian economy and CPP

contributions are in decline.

Finally, investing in rapidly

growing regions allows the

CPP Fund to benefit from the positive demographic growth and rising productivity of those

regions. We find this rationale as relevant today as it was immediately following the elimination

of the foreign property rule.



Smaller and Medium-Sized Institutions

Most smaller and medium-sized institutions have been moving in the same direction, but remain

much more exposed to domestic equities than their larger counterparts. A survey from

Greenwich Associates breaks down the asset mixes of Canadian institutional investors by size,

and these are illustrated in Figure 10 on the previous page. This chart shows that the largest

investors tend to have the smallest allocations to Canadian equities, though at 27% of their equity

allocation on average, these allocations remain significant. Smaller institutional investors tend to

demonstrate the most home country bias with, on average, 44% of their equity allocations

invested in Canadian equities. As a result, it is these smaller and medium-sized institutions that

have the most room to consider reducing their Canadian equity allocations in favour of foreign

equities.

Other Considerations

The earlier analysis focused on the most important considerations in setting the relative size of

Canadian and foreign equity allocations – expectations for risk and return. There are, however, a

number of other issues that will factor into an institutional investor’s asset allocation strategy:

Allocations to other foreign assets. Investors that have large investments in other assets

outside the country, such as fixed income, private equity, infrastructure, or hedge funds, may

choose to retain more of their equities in Canada in order to limit the portfolio’s exposure to

foreign currencies.

Tax considerations. Dividends paid by non-Canadian companies can be subject to

withholding taxes, even for non-taxable investors. Also, taxable investors and Canadian

corporations may get tax benefits on dividends from Canadian corporations.

Belief in the efficacy of active management. Investors may adjust their return expectations

based on the belief that active management works better in some markets than others.

Fees and costs. Investment management fees and expenses are typically higher for non-

North American equities than for U.S. and Canadian equities.

Conclusion

The home country bias of Canadian institutional portfolios has been steadily decreasing for some

time. An analysis of risk and return suggests that this is quite logical and likely has further to go.

Based on assumptions that are consistent with history and appear reasonable looking forward,

Canadian institutions that continue to have 40% or more of their equity allocation invested

within Canada would be well served to consider moving more of their equity allocation outside

of the country. Canadian institutional investors should also consider a meaningful allocation to

emerging market equities, given both the expectation of higher returns the diversification

benefits offered by this asset class.

For additional details, please contact your PH&N IM institutional portfolio manager, or call 1-855-408-6111 or email [email protected]

mailto:[email protected]

Phillips, Hager & North Investment Management Appendix - i

Home Country Bias

Appendix:

The Canadian Dollar as a Natural Investment Hedge

While non-Canadian investments bring with them foreign currency exposure, it may be

misleading to think of this as a “risk” with a negative connotation. An underappreciated

advantage of foreign equities available to Canadians is the buffering effect that foreign currency

exposure has on Canadian portfolios.

Behaviour

The Canadian dollar can

offer a remarkable hedge

against stock market

volatility, and its role as

shock absorber goes back

several decades and is well

established and broadly

based. Figure 11 shows the

positive correlations between

the currency and various

stock markets, and also with the Canadian and U.S. economies. This means that when global

equities tumble, the tendency for the Canadian dollar to weaken during such episodes mutes

those declines once they are translated into Canadian currency.

The correlation is not overwhelmingly high given the many other variables that influence foreign

exchange rates, but the link usually strengthens at extremes, offering help precisely when it is

most needed, such as when markets are doing especially poorly. In fact, we find that each of the

last six major declines in the MSCI World Index (in local currency terms) dating back to the

1980s was helpfully paired with a softer Canadian dollar.

To provide a sense for the usual buffer, around one-tenth of any deceleration in global equities is

typically offset by Canadian dollar adjustments. To be clear, foreign investments should still be

expected to fall in Canadian dollar terms during a correction, but by somewhat less than without

the help of the currency. In sharp contrast, Americans’ international investments tend to suffer an

exaggerated fate in the same scenario due to the proclivity for the U.S. dollar to rise during

crises.

Rationale

Why does the Canadian dollar tend to go down when bad things happen to the global economy

or markets? There are two main reasons.

First, the U.S. dollar remains the world’s safe haven currency. During crises, money flows into

the U.S. to take advantage of the depth, liquidity, and perceived safety of its bond market. As a

result, the Canadian dollar – and indeed most currencies – usually weakens relative to the

Phillips, Hager & North Investment Management ii


greenback. This is important for international investors, as more than half of the MSCI World

Index is made up of U.S. stocks.

Second, the Canadian dollar (and economy) is tightly linked to the resource sector. Over half of

Canadian exports are commodities. Any negative shock to the global economy impacts the

demand for natural resources, and as a result, commodity prices and the Canadian dollar decline

in value. This is why the Canadian dollar tends to underperform most currencies during global

economic downturns.

Outlook

Will this positive relationship between the Canadian dollar and equity markets persist into the

future? It is tempting to argue that the relationship could weaken given Canada’s newfound

reputation for financial sector stability and fiscal restraint. Superficially, the sharp inflow of

foreign investors into the Canadian bond market in recent years would seem to suggest that the

Canadian dollar could even be turning into a “safe-haven lite” currency.

However, we are skeptical of this interpretation. Canadian financial markets are not nearly as

deep as those of the U.S. or Japan, and Canada is not a repository for foreign private wealth, as

Switzerland is. And in fact, there was very little actual inflow to Canada during the worst of the

financial crisis, when a true safe-haven currency would have soared. Instead, the great bulk of

the inflow came afterward, for two artificial reasons.

First, many yield-seeking U.S. investors sought out Canadian bonds given a distaste for the

quantitative-easing induced depressed yields in the U.S. It is theoretically possible that future

market downturns could result in a similar rush, but quantitative easing is an unorthodox tool

rarely deployed outside of extreme crises, and Canadian yields are now broadly lower than in the

U.S.

Second, the other pool of foreign buyers were emerging market central banks seeking to

recalibrate their currency reserves. In a sense, this does reflect Canada’s improved reputation, as

the purchases would not have occurred if Canada was viewed as a risky sovereign. But the

bigger rationale was simply the recognition by central banks that their reserves were too

concentrated in major markets such as the U.S. and Eurozone, and would benefit from greater

diversification to places like Canada and Australia. Now that central banks have reached their

target weights, the bulk of their work (and influence) is complete.

Crucially, central banks are not in the business of buying foreign currencies during crises. To the

contrary, they are more likely to sell their Canadian holdings during the next crisis in an effort to

defend their own currencies.

In conclusion, the Canadian dollar can still be expected to decline in response to future market

and economic downturns, providing a useful if unheralded service to Canadian investors

venturing abroad.

V A N C O U V E R

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This document has been provided by Phillips, Hager & North Investment Management (PH&N IM) for information purposes only and may not be reproduced, distributed or published without the written consent of PH&N IM. It is not intended to provide professional advice and should not be relied upon in that regard.

PH&N IM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by PH&N IM, its affiliates or any other person as to its accuracy, completeness or correctness. We assume no responsibility for any errors or omissions. The views and opinions expressed herein are those of PH&N IM as of the publication date and are subject to change without notice. This information is not intended to be an offer or solicitation to buy or sell securities or to participate in or subscribe for any service.

PH&N IM is a division of RBC Global Asset Management Inc., an indirect, wholly-owned subsidiary of Royal Bank of Canada.

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© RBC Global Asset Management Inc., 2016. Publication date: June 2, 2016. IC1605277

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