How much home country bias is too much?
11 June 2019 | Portfolio construction
Australia’s recent federal election result was a surprise in many respects. This was highlighted by the volume of queries focused on the implications that a Labor proposal to remove franking credit refunds would have on portfolio decisions. In particular, the appropriate level of Australian equity “home bias”.
The concern among investors who had invested and planned their retirement income according to the rules of the day was clearly articulated but regardless of the election outcome the threat of the franking credit policy change prompted a different yet valuable conversation on the risks to a portfolio that come from having a significant home-bias.
The income benefits were given prominence throughout the election campaign. However, an important, and often absent consideration in the conversation, is the degree to which franking credits have been factored into stock prices. After all, the tax benefit only exists if it doesn’t come at the expense of lower future expected returns.
There is a strong argument to make that franking credits are not fully priced - not all investors in Australian shares benefit equally, and a sizeable portion are foreign owned where no benefit from franking is derived.
On the other hand, it is also likely that they are at least partially priced in. Superannuation savings make up approximately 40% of the ownership of Australian shares, and of the super money invested in Australian shares, approximately one third is in draw down phase, meaning there is a significant benefit derived from franking credit refunds, in particular for those in the zero tax bracket.
So now the election dust has settled it is perhaps timely for investors to ask themselves how much home bias is too much. There is a risk that a number of investors have become too complacent about the risks of holding a high concentration to Australian equities, and in many cases the exposure might be made up of just a handful of individual companies. Perhaps the source of complacency relates to Australia’s persistent run of luck—almost 30 years of consecutive growth without a recession places us in a unique position globally.
The level of equity home bias in Australian portfolios is among the highest in the world. The average exposure to Australian equities within My Super default funds, comprises over 40% of the equity allocation, as reported by APRA. This compares to Australia’s market cap within global indices of around 3%.
There are a number of reasons why investors prefer home country equities, some of which are behavioural and some of which have sound investment rationale—a preference for the familiar, ease of access, aversion to currency risk, tax benefits and liability hedging to name a few.
For investors who have gained comfort with even higher levels of home-bias, it is prudent to consider the potential outcomes that such a concentrated position may deliver.
Concentration risk may come in the form of a housing market weakness, a China hard landing, regulatory risk, such as the recent tax changes proposed, or contagion risk from global events such as the US-China trade war or Brexit, all of which may impact our market in unanticipated ways.
If franking credit refunds had been removed - and not all investors would have been affected equally by the change - it would have likely been a catalyst for many to review home-bias positions within portfolios, triggering an incremental shift toward more globally diversified portfolios, which could help insulate Australia’s savings, much of which is in our superannuation system, from unanticipated risks.
While the right level of home-bias may differ by investor, considering key factors such as the diversification benefit of adding foreign securities, local-market sector and security concentration, as well as domestic tax treatment, provide a sound basis for setting allocations.
To date, home country bias hasn’t carried a high penalty, providing a timely opportunity to review areas of excessive concentration risk. Some of the structural tailwinds that have aided the Australian economy in the past may not play out the same way in the future. So if Australia’s dream run comes to an end, investors may start to feel the pain, particularly when their standard of living in retirement is at stake.
This article originally appeared in the Australian Financial Review on Monday, 3 June 2019.
Written by Aidan Geysen, Senior Investment Strategist and Manager at Vanguard.
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Aidan Geysen, Senior Investment Strategist and Manager with Vanguard’s Investment Strategy Group, shares investment and personal finance insights gained from his role where Aidan is responsible for developing and delivering research insights into portfolio construction, exchange traded funds, and investment markets .