Home Bias Paradox?

[Chloe]

It's taken me 5 years to realise this, so please feel free to 'Tut' and pass by. But it must have been discussed before and I would be grateful for a reference before the treasures of TMF are dumped into oblivion.
Passive investors 'buy the market' via index trackers, and hold a share of all the listed companies in proportion to their market capitalisation. The funds make compromises and optimisations that deviate from this slightly - sometimes there is sampling and (I assume) a whole raft of smaller companies are omitted. But, in essence, it's what the funds attempt and their deviations from their index's performance is a measure of their success.
So, provided there are trackers available, the investor should be able to buy one (world) equities tracker fund, and that's it for their equities investment.

But many, self included, don't buy a world tracker, but buy a mix of world subset trackers in accord with a self-designed allocation (x% UK equities, y% US equities, etc.) in proportions that are not the same as that of the world tracker and we re-balance them so that the proportions remain the same.

With a world tracker approach, we effectively buy more of companies increasing in value and less of companies that decrease in value.
With the self-allocation and re-balancing, we effectively buy more of backsliding economies and sell those that are succeeding. I guess the world tracker enthusiasts would say:
a) Self-allocators are supporting failing economic areas
b) Self-allocators are embracing passive investing and then failing to follow it.
c) Self-allocators are conflicted: they start off by saying the market knows best and then they can't resist knowing better than the market, themselves.

Of course, home bias is easy to understand and difficult to avoid (although reflecting on the effects of the pound's devaluation over the last year or so may give you doubts, especially as you've probably had to rebalance and lose potential paper profit).

There are, of course, assets other than equities and the investor has to be a self-allocator as far as the choice of equities:bonds:commodities:etc is concerned.

Is there really a justification for biases if you are a 'true believer' passive investor? Should requests from new converts to passive investing, who ask for comments on their proposed allocations, start by saying that a world tracker for their equities is an alternative they should consider (VWRL, Lifestrategy 100, etc.)?

CB

[Generali]

I suppose that a home bias is reasonable to some extent. If you are planning to retire in the UK, for example, then having a currency bias towards the UK seems desirable from a risk management POV.

I suppose if you plan to travel a lot in retirement so you are less fussed about currency risk then the best thing to do is invest in a MSCI World tracker.

[hamzahf]

Is there really a justification for biases if you are a 'true believer' passive investor? Should requests from new converts to passive investing, who ask for comments on their proposed allocations, start by saying that a world tracker for their equities is an alternative they should consider (VWRL, Lifestrategy 100, etc.)?
CB

I think many would now advocate a global tracker fund of some description (one can argue about the relative composition). That is the central argument of Lars Kroijer for example.

http://monevator.com/why-a-total-world- ... -you-need/

However, the UK stock market is a little unusual by virtue of a high global exposure from it's major constituents. That a UK index tracker can have very low fees might be seen as an attraction. The significant rise of the FTSE-100 as sterling fell is a good illustration of the non-sterling trading value to it's constituent companies.

Regards
Hamzah

[gryffron]

With a world tracker approach, we effectively buy more of companies increasing in value and less of companies that decrease in value.

If you actually look at the constituents of global trackers they generally include only massive global companies, Samsung, Toyota, Sony, a few Aussie banks and miners. And virtually nothing of China and India. Several reasons for that:

1) Their companies and stock markets are small in value compared to US/UK. So if they feature at all in your global tracker, they are likely to be a miniscule proportion.
2) They have poorly regulated stock markets. Difficult to trade in reliable companies rather than "duff" scam ones.
3) Much of the growing business in China, Brazil, and especially India is privately owned, rather than stock market traded.

So I'm not convinced global trackers are as useful as you say. As Hamzah says, FTSE100 earnings are sufficiently international for most investors.

gryff

[TedSwippet]

A few years ago, Vanguard published a paper analysing the effects of various degrees of home country bias for a few countries, including the UK.

[hamzahf]

The FT100 is something like 70% foreign earnings and even the FT250 is around 50% foreign.

I found that fact to be retrospectively useful when analysing the composition of the passive global equity portfolio that I devised. Although nominally 19% UK, taking those proportions into account results in about 9% UK final. Primarily to test posting capabilities here is some more detail.

Code: Select all

Vanguard FTSE Dev World ex UK Equity Index Acc Fund 40%
Vanguard Global Small Cap Index Fund Class Accumulation Fund 12%
HSBC FTSE 250 Index Accumulation C Fund 12%
BlackRock Emerging Markets Equity Tracker Fund D Accumulating Fund 10%
Vanguard FTSE Developed Europe ex UK Equity Index Acc Fund 8%
HSBC FTSE 100 Index Fund Accumulation C Fund 8%
BlackRock Pacific ex Japan Equity Tracker Fund D Acc Fund 7%
BlackRock Japan Equity Tracker Fund D Acc Fund 3%


It is also possible to review the detailed composition of this blend using a Morningstar X-ray analysis (free if you jump straight to the Instant X-ray page).

http://tools.morningstar.co.uk/uk/xray/ ... geId=en-GB

The tiny url link shows this portfolio X-ray. Using the Vanguard Lifestrategy 100% fund as a template, I boosted the global small cap coverage and emerging market/ asia pacific elements. I previously described the portfolio as P5P3B4 on TMF; this is the P5P3 element.

http://tinyurl.com/z3j6q4f

Regards
Hamzah

[hiriskpaul]

But many, self included, don't buy a world tracker, but buy a mix of world subset trackers in accord with a self-designed allocation (x% UK equities, y% US equities, etc.) in proportions that are not the same as that of the world tracker and we re-balance them so that the proportions remain the same.

That's what I do, but there is no reason why someone would need to do that. You could buy according to precise current market weights and not rebalance. Your allocation will slowly drift, but not by much and could easily be corrected through dividend reinvestment on its own. When someones portfolio reaches a certain size it becomes cheaper to hold a set of geographical trackers than a global tracker. There can also be tax advantages to splitting geographically. For example, higher rate taxpayers might prefer to hold lower yielding trackers outside tax shelters to reduce their income tax liability, assuming they have insufficient space available for the whole portfolio inside tax shelters. Another good reason to split is to hold US listed ETFs inside SIPPs to eliminate the withholding tax on one's US investments.

Another approach that some people use is to vary allocation according to some metric such as CAPE, in an attempt to increase weighting in cheaper markets. They then rebalance according to some variable allocation formula rather than back to fixed weights.

With a world tracker approach, we effectively buy more of companies increasing in value and less of companies that decrease in value.
With the self-allocation and re-balancing, we effectively buy more of backsliding economies and sell those that are succeeding. I guess the world tracker enthusiasts would say:
a) Self-allocators are supporting failing economic areas
b) Self-allocators are embracing passive investing and then failing to follow it.
c) Self-allocators are conflicted: they start off by saying the market knows best and then they can't resist knowing better than the market, themselves.

Not quite right. When you buy a global cap weighted tracker, you are buying the exact same proportion of each constituent company's shares. You don't buy a bigger proportion of Apple shares than say Tesco shares. That does mean that more of your money has gone into Apple shares than Tesco, but that is not the same as saying you are buying more of Apple than Tesco, or more of companies increasing in value and less in those decreasing. You are buying the same amount of each company. This has the advantage that the entire portfolio remains in balance through share price movements.

The purist view is to say that the market's allocation of capital is probably better than I can manage. I have some sympathy with that, but history shows that investors are not rational and do not allocate capital in rational ways. For example, we know that investor home bias does exist and is likely part of the reason for the crazy valuations of Japanese equities in the 80s. Whilst investor irrationality exists then, is it not better from a risk management perspective to cap the exposure to particular geographical regions? The CAPE allocators go one step further and say that there is an empirical link between the CAPE you buy at and subsequent long term returns. As such, they are seeking an edge, or lowering risk, by overweighting regions with lower CAPEs. Personally I don't have a problem if someone wants to do something like that, but I have doubts it will achieve very much after trading costs unless CAPEs are sitting at extremely different values, as they were in the 80s.

Of course, home bias is easy to understand and difficult to avoid (although reflecting on the effects of the pound's devaluation over the last year or so may give you doubts, especially as you've probably had to rebalance and lose potential paper profit).

I would say that home bias is very easy to avoid these days. I don't do it in my global equities portfolio, although I do in niche areas such as VCTs and private equity. The main problem I have with home bias is the horrible sector weights of the UK market and the only good reason I can think of for home bias is that UK trackers are available for very low running costs. Only US market trackers have lower running costs.

Since 2012 I have split my global equity portfolio roughly 40% US, 20% Europe, 10% UK, 10% Japan 10% Global EM, 7% developed asia/pacific, 3% Canada. Now mostly ETFs and trackers, but I have a few legacy ITs and I tilt towards small caps, value and low volatility.

[GrahamPlatt]

Interesting table in this recent post re cap weighted vs. Equal weighted portfolios:
viewtopic.php?f=15&t=432&hilit=Cap+weighted&start=20#p4308

[hiriskpaul]

Interesting table in this recent post re cap weighted vs. Equal weighted portfolios:
http://www.lemonfool.co.uk/viewtopic.ph ... t=20#p4308

This century small caps have knocked spots off big caps. Equal weighting means increasing the weight of smaller caps at the expense of larger caps, so it is not too surprising that equal weight has been a good strategy this century. I doubt equal weighting would have been better in the 90s.

I suspect it is likely to be cheaper to buy a small cap tracker to increase weighting to small caps rather than buying an equal weighted ETF. That is what I do.

[Chloe]

I'll say a big thank you in case a flurry of discussion about even weighting vs cap weighting submerges the original questions. And particularly:'

Hamzah:
What a great tool the Morningstar XRay is; thank you for the reference and for prompting me to find out what tinyurl is.

TedSwippet: Yes, an interesting paper. More so for an Australian or Canadian, I guess. If it were quantitative about the weightings to be given to the various considerations ... I suppose it's all part of their (Vanguard's) brand promotion, but they do write a fair amount of interesting and useful stuff.

hiriskpaul: Now I know what CAPE is. Searches bring up Meb Faber and after reading some, I realise he's also associated with a timing method that turned up recently in discussions of Seasonalities (or something) on TMF. In the end, I concluded that even the latter, much simpler than CAPE to put into practice I would think, probably required more application and discipline than I have.
As regards not being able to avoid home bias, I should have made it clear my home bias is mainly because of emotional/irrationality factors, rather than there not being appropriate vehicles available. I had assumed that it's not just me.
I can see from the Vanguard paper and others' responses that there are all sorts of justifications for home bias, but I shall try to reduce mine, at least until Brexit starts to make us all rich.

Thank you,
CB

[Hariseldon58]

I would suggest that if you invest in a diverse portfolio of shares via very low cost trackers , minimise trading then you will probably do just fine over a period of years.

Whether is was an All World tracker like VWRL, a subset of trackers that cover various global markets (an approach I favour) then over time the results will probably be broadly similar.

Men Faber has written a short ebook on global asset allocation and the conclusion was that over a period of many years if you stuck to one approach then the results were all very comparable but the most significant factor was keeping costs very low.

The costs that you face are not always very clear , even the index with which you compare the performance of your tracker may be a net tracker which deducts dividend taxes at a rate higher than you will pay thus many low cost trackers of the S&P500 appear to have beaten the index they track !

This may appear unnecessarily complex but doing very little is very rewarding so whilst I do occasionally deal tactically I would probably do as well doing nothing, the temptation is to try too hard.

[foxy]

Chloe

I am a passive investor and run a boring portfolio.

I hold vanguard lifestyle 60% equities accumulation as one portfolio

I also have a keep it simply stupid five holding fund as another.

They are fine. I have not had to do anything with them for years other than drip a bit of money in when people say don't and reinvest dividends in the worst sectors.

The returns have not been boring.

My trading costs equate to a cup of coffee as and when.

My research time spent on possible best alternatives, beta funds, and all the other hindsight stuff is nil.

Zen on.

[GeoffF100]

I looked at this last year. I found an article from a firm of actuaries that said that for a UK investor, volatility was minimised by a 50% allocation of overseas stocks, over the period that they considered:

http://www.barkertatham.com/overseas-equities/

The Vanguard article quoted earlier in the thread said that volatility was minimised by a 20% allocation to overseas stocks, over the period that they considered, which is strange. I used Vanguard's data for their Developed World ex UK fund and historical values for my UK portfolio, and found that volatility was minimised by 60% overseas stock. I am currently about 50% overseas stock, but will probably increase that to 60% or more.

A factor not mentioned in that Vanguard article is high rate tax. Foreign companies tend to have lower yields, as a result of buying back shares rather than paying dividends. If this keeps you out of high rate tax, that offsets the withholding tax.

Here is a more up to date Vanguard article:

https://www.vanguard.co.uk/documents/ad ... -tlisg.pdf

The asset allocation that historically minimised volatility was very time dependent.

Asset managers as a whole allocated 32% of their UK equity holding to the UK in 2014:

http://www.theinvestmentassociation.org ... survey.pdf

It would appear that the professionals have come to much the same conclusions as me.

Emerging markets have a much bigger share of market capitalisation than one of the previous posts suggested.

Re-balancing a portfolio to fixed proportions is very dangerous if one of the constituents keeps falling in value. Money keeps being fed into the falling constituent, until you lose it all. Similarly, if a constituent keeps rising in value, it keeps being sold to buy worse performing constituents. If you must re-balance, it is much safer to do it with cash inflows or outflows than by selling stock.

[Chloe]

Geoff100,
Yes, it's the point covered by your last para that was my personal revelation and prompted the original post. Rebalancing to fixed proportions of different asset classes, as with e.g. 60%equities to 40% bonds, makes sense. Not so a home (or other) bias of x% unless x changes when there is a material change in the region's share of the total market.

CB

[GeoffF100]

Rebalancing to fixed proportions of different asset classes, as with e.g. 60%equities to 40% bonds, makes sense.

That is very dangerous. If the equities gradually shrink to zero, and you keep rebalancing, you lose all of your money. If you do not re-balance, you keep 40% of it.

[TedSwippet]

That is very dangerous. If the equities gradually shrink to zero, and you keep rebalancing, you lose all of your money. If you do not re-balance, you keep 40% of it.

Not something to worry over. The chance of a globally diversified stock allocation going to zero is essentially nil.

[foxy]

Rebalancing to fixed proportions of different asset classes, as with e.g. 60%equities to 40% bonds, makes sense.


That is very dangerous. If the equities gradually shrink to zero, and you keep rebalancing, you lose all of your money. If you do not re-balance, you keep 40% of it.

No you don't.

Bonds are dangerous as well.

You could lose 99.999% of your money. Very very dangerous.

Seriously guys cannot we wrap this nonsense up and change the board definition to exclude momentum investing.

[GeoffF100]

Passive investment, as recommended by financial theory, involves holding a market weighted portfolio of all the investments available to you, without re-balancing.

Re-balancing in a falling market is a mild version of averaging down. That is great if the market recovers, bad if it does not. Only two stock markets have lasted 100 years. It is true that the global market as a whole is unlikely to crash to zero, and that even the safest bond holding would not be completely safe if it did. Nonetheless, the global market certainly could crash to a quarter or less of its current value, which is unlikely to happen to AAA rated bonds. Buying more of a falling asset is dangerous. It is safer to just buy and hold as financial theory recommends.

The old stock market adage is important here. Do not invest money in equities unless you can afford to lose it. Equities are riskier than bonds.

[Hariseldon58]

It is prudent to think about the price (value) of what you buy.

Following theory in 1989 and holding an increasing share of Japanese equities in a World Portfolio was a mistake.

Buying a 10 year bond with a negative return is not offering value, it is dangerous to rely on the greater fool theory to bale you out.

EG If Emerging Markets are out of favour as a whole and are 'cheap' then buying more of them could prove rewarding...if you sold down a market holding of an investment that appears very expensive on fundamentals. You don't have to bet the farm, just make a gradual shift.

If one sticks with the World Tracker then you probably won't come to much harm but small tactical movements towards value can be profitable in my experience.

[GeoffF100]

Following theory in 1989 and holding an increasing share of Japanese equities in a World Portfolio was a mistake.

If you follow theory, just continue to hold the Japanese equities that you already have. With hindsight, you could have done better by selling just as the Japanese market topped out and re-buying them when it bottom out. The problem is that there is no reliable way of knowing when a market have tops out or bottoms out. Nobody rings a bell. Human investors are not entirely rational, but nobody can predict just how irrational they will be. Value is likely to out in the end, but the market remain irrational for longer than you can remain solvent.

Back-testing can be very misleading here. In recent decades major stock markets have always recovered. That was not true in the past. If you back test re-balancing over recent decades it is easy to delude yourself (or your hapless clients) into thinking that it is a free lunch, but that will not always be so. Nobody can predict the future. The whole of North America would be devastated if the caldera under Yellowstone Park blew. Passively holding a world tracker is safer than re-balancing. Financial theory is not wrong.

If you are investing regularly, you can just buy a little world tracker each year, and your luck should average out. If you have a large sum to invest, there is nothing better than to take a gamble and buy a world tracker in one go, but you could lose it all.