In Forget the Noise, I propose building an income stream by using a majority of South African-listed assets. I have been doing a lot of reading recently which challenges this belief. There is, of course, a lot of noise in the SA press about "state capture", "corruption" and "Guptas". None of this noise is great but it is not the source of my worries. You see my worry is that South Africa is a tiny part of the global market. I am taking a massive bet on South Africa. The whole Middle East/Africa region only makes up 1.2% of the entire MSCI World index (i.e. South Africa is less than 1.2%). The average South African investor has far more than 1.2% invested in SA assets. (This so-called Home Country Bias is not unique to South Africa, either. See this Reformed Broker blog post.) Regulations such as Regulation 28 in South Africa do not help either as they only allow up to 25% of invested assets offshore.The question I ask myself daily at the moment is whether I am right to invest mainly in South Africa or should I be sending more money offshore. In the Reformed Broker post, Josh Brown cites a Vanguard study* with some reasons for Home Country Bias:
- Expectations. In one of the earliest studies on the topic, French and Poterba (1991) identified investors’ expectations about future returns in their home market as a key driver.
- Preference for the familiar. Investors generally feel more comfortable with their home market and allocate investments accordingly, even if it results in a poorer risk/return trade-off for their portfolio.
- Corporate governance. Dahlquist et al. (2002) suggested that corporate governance practices have a major impact.
- Liability hedging. Stockton and Bosse (2015) illustrated that the need to hedge certain liabilities may lead to a home-country bias, especially in fixed income, but also perhaps in equities. This is because the ability to fund a clearly defined liability is increased when using assets that move in tandem with those liabilities. Similarly, domestic investor spending is often influenced more by domestic inflation and interest rates.
- Multinational companies. Investors may feel that through investment in multinational companies, they will attain as much global diversification as they will need. But as global economies become more interconnected, it’s important to consider the extent to which investment in domestic companies provides exposure to foreign markets.
- Currency. Many investors perceive foreign investments as inherently more risky than domestic holdings. For example, it is not uncommon to see investment providers’ websites or literature list foreign equities among the riskiest assets, despite the well-documented diversification benefits of including foreign securities in a diversified portfolio. Much of the volatility in foreign investing can be attributed to exchange-rate fluctuations, and the desire to avoid the influence of such movements could be an additional reason why investors allocate greater percentages of their portfolios to domestic securities.
In my case, the reason for my Home Country Bias is Liability Hedging. I want to build an income stream that is inflation-hedged. I still believe that this is a valid approach. What I do concede, however, is that I should pay more attention to building an offshore allocation that is more representative of the global economy. I am still pondering exactly what that allocation should look like. This has been a good exercise, though. We must continually test our beliefs and thinking.
*The buck stops here: The global case for strategic asset allocation and an examination of home bias Vanguard – July 2016
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