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Diversification is crucial for investors looking to reduce portfolio risk over time, and foreign securities play a vital role in achieving this objective.
However, investors often ask, “How much should I allocate to local versus global stocks?” Financial theory suggests that investors should align their asset class exposure with global market capitalizations because they represent the consensus asset allocation of investors at any given point in time.
Therefore, market-cap-weighted indexes serve as a valuable asset allocation starting point for most investors. For example, as of June 30, 2022, a forward-looking efficient portfolio should only allocate about 3.4% of equities to Canadian stocks, since they accounted for the same percentage of the global equity market on that date. However, as shown in Figure 1, according to the International Monetary Fund, Canadian investors allocated 52.2% of their total equity allocation to Canadian equities, over 15 times overweight. Despite the benefits of diversifying a portfolio globally, home bias has been strong among Canadian investors.
Home bias is a recognized global phenomenon where investors intentionally overweight domestic holdings at the expense of foreign securities, as shown in Figure 2. Various theories have been proposed to explain this bias, including expectations of future return differentials, preference for the familiar, corporate governance standards, the need to hedge domestic liabilities, perceived global exposure through multinationals, favourable tax considerations, and currency risk. But this bias has significant implications as it prevents investors from achieving broad diversification across global markets.
However, Vanguard believes the optimal asset allocation for Canadian investors is 30% vs 70% allocation to Canadian versus international equities, based on our research, which we will delve into further.
1. Security concentration. Figure 3 shows the leading 10 holdings in the Canadian and global equity markets. It is evident that Canada exhibits a greater level of concentration compared with the global equity market. Specifically, the top 10 holdings in Canada constitute almost 37% of the index. Conversely, the top global securities make up less than 16% of the global market. This could contribute to idiosyncratic risk, a form of risk that is peculiar to investing in a certain geography or market and can be avoided by diversification.
2. Sector concentration. When we analyze security concentrations, it becomes evident that Canadian equity portfolios tend to be heavily invested in specific sectors or industries. In Figure 4, we compare the weight of the top 10 equity sectors in Canada to their weight in the global equities market.
The Canadian equity market is significantly overweight in the energy and financials sectors, with relatively smaller overweight in materials and industrials. However, this results in information technology, healthcare, consumer discretionary and consumer staples being underweight relative to the global market.
3. Inefficient portfolio allocation. Although investors may have unique reasons or justifications for home bias, its direct implication for security and sector concentrations is that Canadian investors are exposed to a considerable amount of risk that could have been diversified away.
Figure 5 illustrates the historical risk and return of the global equity market (blue dot), Canadian equity market (red dot), along with the returns and volatilities of many countries of the global index (various colors). Additionally, a theoretical forward-looking efficient frontier, represented by the yellow curve, is shown.
Two key takeaways can be drawn from this graph: First, the Canadian stock market has historically been more volatile than the global market, but without a proportionate increase in return (in fact, all individual countries have had greater risk than the global index). Second, in a forward-looking context, any portfolio that deviates from the global market is, by definition, inefficient.
Next time: Canadian home bias and modern portfolio theory, and how to find optimal home bias allocation for portfolios.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
Notes
1. Global return data covers the period January 29, 1988 through May 31, 2023; Canada return data covers the period January 30, 2004 through May 31, 2023; Germany return data covers the period February 26, 1999 through May 31, 2023; Japan return data covers the period February 26, 1971 through May 31, 2023; United Kingdom return data covers the period February 26, 1971 through May 31, 2023; Australia return data covers the period February 26, 1971 through May 31, 2023; EU return data covers the period February 26, 1999 through May 31, 2023; and Emerging Markets return data covers the period January 29, 1988 through May 31, 2023. The return points are historical, while the curve is purely theoretical and forward looking.
Disclaimer
© 2023 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared July 5, 2023, on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
Certain statements contained in this material may be considered “forward-looking information” which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.
This material is not a recommendation, offer or solicitation to buy or sell any security, including any security of any investment fund or any other financial instrument. The information contained in this material is not investment advice and is not tailored to the needs or circumstances of any investor, nor does the information constitute business, financial, tax, legal, regulatory, accounting or any other advice.
The information contained in this material may not be specific to the context of the Canadian capital markets and may contain data and analysis specific to non-Canadian markets and products.
The information contained in this material is for informational purposes only and should not be used as the basis of any investment recommendation. Investors should consult a financial, tax and/or other professional advisor for information applicable to their specific situation.
All monetary figures are expressed in Canadian dollars unless otherwise noted.
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