Date
8 December 2016
The first true period of geographical diversification typically begins with investors making small but permanent allocation to international products. Photo: bankingbaku.az
The first true period of geographical diversification typically begins with investors making small but permanent allocation to international products. Photo: bankingbaku.az

Investment allocation: Home bias vs int’l diversification

For institutional investors, diversification has long been a tool to reduce overall risks on investments and boost long-term returns.

After focusing on diversification into different asset classes in the early years, leading institutions in developed countries have been spreading their portfolios geographically in the last three decades.

If we look at the United States, international allocation from that market has gone through several stages.

In “period zero”, investors eyeing other markets were mainly prompted by the goal of additional return, especially when the home market seemed stagnant or overpriced.

This stage requires investors to be familiar enough with other regions, so as to feel comfortable about investing, and to have enough financial literacy to choose an appropriate strategy.

Coming to Hong Kong, we’ve seen many international opportunities being pitched for local investors in the past several years. One example is the numerous marketing events for overseas residential property.

The first true period typically begins with investors making small but permanent allocation to international products.

The investment rationale is this: as different countries have separate economic and investment cycles, making permanent allocations can help investors diversify long-term risks.

Typically, an investor would start with a geographic exposure into a familiar asset class. For example, a person may add a European equities fund to his existing equity allocation. At this stage, however, the international allocation is likely to remain small.

In the second stage, investors would evaluate the global economy as a whole and make allocation based on some measure of relative size.

Some may reference the relative GDP of each economy, and others may reference the size of the specific product they are interested in.

For example, one would bear in mind that Asia Pacific REITs represent about 25 percent of global REITs in terms of market cap, with the rest being dominated by North American and European REITs. Given this, a global REIT program is likely to be a portfolio with exposure in North America, Asia Pacific, and Europe.

Now, even after a long-term allocation goal has been established, many people tend to remain over-invested in their home markets. This phenomenon, known as home market bias, may have several reasons.

First, some investors are merely in transition, as they gradually increase their exposure to international markets. The investment team may need time to develop the expertise necessary for evaluating international opportunities, and investors may consciously choose to slow down the diversification process to allow time to capture better entry point in each market.

While these tactics are valid, delaying allocation for too long can cause some problems, especially if the home market sees any unforeseen weakness.

Given this, it is recommended that investors should complete their international allocation as soon as practical.

Second, many investors naturally see many opportunities in their home markets. This aspect of the home market bias stems from a simple self-selection effect.

Large investors are by definition those that are successful in earning the first bucket of gold in their home markets. This means that the decision makers, especially if they are the founding members, are pre-selected to be especially suitable to navigate through home markets.

Thus, they are often able to identify home market opportunities before others can, putting them in a good position to achieve further investment success at home.

Family offices are often formed either in the waning years of the founding patriarch or by the second or third generation.

It is because of the belief that only with such an arrangement will it make sense for the family to step back from actively pursuing projects in the home market.

As many Asian economies reach maturity stage, we can expect internationalization to become a stronger theme in the region in the decades ahead.

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RC

Chief Investment Officer, Admiral Investment Ltd.

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