Home bias offers some natural advantages, in terms of local knowledge and being invested in your own currency.
But there are clear downsides to focusing too narrowly on one market, which defies the usual investing wisdom to spread your risk, and cuts you off from valuable opportunities.
We asked financial experts how investors should approach splitting an Isa portfolio between the UK and the rest of the world.
They discuss the pros and cons of home bias, how much domestic exposure is about right considering the UK only represents around 5 per cent of the world market, and whether it’s a good time to be ‘overweight’ in local investments.
Domestic outlook: How should investors approach splitting an Isa portfolio between the UK and the rest of the world?
What are the advantages of ‘home bias’ towards the UK?
Knowledge: ‘It’s no bad thing to know and understand the companies you invest in, which is often the reason investors skew their portfolios towards their home market at the expense of other regions,’ says Ed Monk, associate director of personal investing at Fidelity International.
Special features: The risk from home bias is reduced somewhat because the UK market includes many large companies which earn their money around the world, notes Monk.
He says: ‘As much as 70 per cent of the earnings of FTSE 100 companies are made overseas – so when you buy a slice of the UK market you are actually getting exposure to the growth in many other economies as well.’
Monk adds that the UK market has high exposure to sectors like commodities, financials and consumer staples, which have defensive characteristics that do well during certain periods.
For example, he says home bias worked in investors’ favour for several years after the financial crisis, but the picture has become less rosy in the past few years as the rapid rise of US tech companies has left the UK in its wake, including during the pandemic.
Dividends: The sectors mentioned above have also historically paid a good income, which has made the UK appealing to many small investors, says Monk.
They might either want the income, or like the stability that dividends provide to a total return when they are reinvested, he explains.
Ed Monk: ‘It’s no bad thing to know and understand the companies you invest in’
Iain Barnes, head of portfolio management at Netwealth, points out that the larger UK stocks represented by the FTSE 100 now offer twice the level of dividend yield as the US stock market.
In the US, companies tend to reinvest their profits more readily for future growth, rather than distribute them to investors, he says.
‘At times, this dependability of cashflow is sought after, although we would be wary of any concentrated strategy that relies on the dividends of any one company, as accidents can happen.’
Currency: Currency management is key to prospective returns, and UK equity allocations are an effective lever to control exposure to currency risk, according to Barnes.
‘Investing on an international basis brings either an additional layer of currency risk or the additional cost of hedging,’ he says.
‘That said, looking under the bonnet of a UK fund is key to understanding where many of the global companies that make up the FTSE 100 earn their revenues, as that will influence the dynamic between currency movements and companies’ share prices.’
What are the disadvantages of favouring your home market?
Opportunity: ‘A higher international weighting over the past 10 or 25 years has made little difference to a portfolio’s volatility while giving one access to a much wider universe of stocks,’ says Rupert Thompson, chief investment officer at Kingswood.
Will Hobbs, chief investment officer at Barclays Wealth & Investments, says geographical bias not only limits your opportunities, but also skews a portfolio towards certain sectors and styles which can have a significant impact on performance.
Iain Barnes: Political uncertainty and sluggish economic growth have caused international investors to ignore FTSE firms
‘The more narrow you fashion your investment net, the more likely you will miss or only partially gather the incoming profits haul. The other linked point is associated with risks.
‘Not only do you narrow your return horizons by focusing on the overly familiar, but you concentrate the idiosyncratic risks you are exposed to – political, economic and beyond.’
Winners: Thompson says UK investors with a greater international weighting in their portfolio would have had more exposure to the big winner of the last decade – the tech sector, in which he says the UK is ‘woefully underweight’.
‘Maintaining an exposure to the key long term growth areas – be it tech or now climate change – is at least as important as having the right regional exposure.’
Innovation: ‘History has shown that the next technological breakthrough could come from anywhere, at any time, and from anyone. As such, focusing on one particular country, sector or company, may inhibit your return prospects,’ says Hobbs.
How much should you allocate to the UK?
‘While the decision to overweight the UK is important, an equally crucial but sometimes overlooked consideration is the appropriate neutral allocation to base an overweight on,’ says Thompson.
‘The UK now only accounts for no more than 4 per cent of the global equity index and a critical judgement is how large a home bias is justified.
‘We believe an appropriate neutral UK allocation is no more than 25 per cent, whereas traditionally it has been allocated as much as 50 per cent.’
Ed Monk, of Fidelity, says that while the UK only makes up around 5 per cent of the global stock market by value, many investors would see that as quite low exposure to their home market.
He puts the proportion investors should aim for just above this, saying: ‘Between 5 per cent and 10 per cent is a typical allocation.
‘If you’re confident in the UK, an allocation at the top of this range, with a tilt towards mid and small-sized companies, makes sense.’
Is it a good time to give a heavier weighting to the UK?
Rupert Thompson: UK is ‘woefully underweight’ in the big winner of the last decade – the tech sector
The UK market is cheap compared with the rest of the world, and the economy is on the cusp of a sharp rebound after the rapid vaccine roll-out, says Rupert Thompson of Kingswood.
‘That said, with 75 per cent of FTSE 100 revenues coming from overseas, the primary reason for overweighting the UK is its cheapness, unless one is focusing on the more domestic-oriented areas of the market such as small and mid-cap stocks.’
Iain Barnes says at the moment, Netwealth portfolios are exposed to the small and medium-sized companies in the FTSE 250 index.
‘Political uncertainty and sluggish economic growth have caused international investors to ignore these companies which are more geared to the domestic outlook that we think is now improving.’
Monk says: ‘The situation right now, with Britain among the first countries to roll out vaccines, means the UK is trading on a valuation that seems at odds with the country’s immediate prospects.
‘The IMF expects a 5.3 per cent rise in GDP this year, faster than for advanced economies generally.
‘UK shares are cheap, however you choose to measure them. Against earnings, against assets and notably when compared with dividends, even after last year’s cut in payouts. Home bias to the UK may not be the worst idea.’
Why do many people prefer to invest in their home markets?
UK investors are often tempted to allocate more of their portfolio to their own market, according to Rob Smith, head of behavioural finance at Barclays Wealth & Investments.
He says familiarity with a local economy can make it seem less risky than it actually is, while investors often add a risk penalty to foreign assets simply because they understand them less.
Rob Smith: Behavioural investing expert
This lack of understanding can encompass company names, legal structures, currency, and corporate governance standards.
‘Unfamiliarity creates more doubt and the perception of greater risk, which can make investing in foreign markets less appealing and the case for investing in your home market more compelling,’ says Smith.
‘Investors may also be influenced by the perceived impact their investments have – specifically the feeling that by investing in UK stocks and shares, they are investing in and supporting the UK economy.’
Smith says familiarity bias is fine up to a point as it encourages people to invest, but too much is likely to be costly.
‘There is a balance to strike between your comfort with a home-biased portfolio and potentially more efficient investments with which you are less familiar.
‘At the end of the day it is better to be invested with a UK bias than not at all.
‘But, if you’re looking to ease yourself into the market, investing in a highly-regarded and diversified fund will likely be the best way to do so, whilst removing some of the issues around familiarity and “home bias”.’
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