Clients may be feeling patriotic ahead of the Canada Day long weekend, but that enthusiasm shouldn’t extend to their investment portfolios.
A report from Vanguard Investments Canada this week examined the consequences of home bias and sought to find the appropriate asset mix. While global equity exposure reduces volatility and risk, what is the optimal asset allocation for Canadian investors?
The report said Canadian stocks make up only about 3.4% of the global equity market, yet Canadian investors allocated 52% of their total equity allocation to Canadian stocks (according to International Monetary Fund data from a year ago), making them 15 times overweight.
Home bias can be attributed to a preference for the familiar, corporate governance standards, tax considerations, currency risk and other factors. And while some of these reasons are sound, too many Canadian investors are missing out on the benefits of global diversification, the report from senior investment strategist Bilal Hasanjee said.
One consequence of Canadian home bias is security concentration. The top 10 holdings in Canada constitute almost 37% of the FTSE Canada All Cap Index, compared to the 15.6% for the top 10 holdings in the FTSE Global All Cap Index, according to Vanguard.
“This could contribute to idiosyncratic risk, a form of risk which is peculiar to investing in a certain geography or market and can be avoided by diversification,” Hasanjee wrote.
The Canadian equity market is also significantly overweight in financials and energy, leaving investors underexposed to sectors such as information technology, health care, consumer discretionary and consumer staples relative to the global market.
While global diversification reduces volatility and risk, Hasanjee found that the benefits began to decline at a certain threshold. In addition to market concentration risks and the diversification benefit, he considered factors such as tax and trading costs, currency impacts and regulatory restrictions to come up with an appropriate mix.
“Looking at the data, the optimal asset allocation for Canadian investors is a 30% allocation to Canadian equities and a 70% allocation to international equities because it has shown to minimize the long-term volatility of their portfolio,” he wrote.
The report notes that home bias has been declining in Canada (and in other countries) as investors embrace broader diversification. In Canada, the average weight of domestic equities has dropped from around 65% in 2012.