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Why the home bias?

Created:
30 June 2006

So you’re thinking of investing overseas? Here’s some advice – don’t bother. As a way of spreading risk, investing in major overseas stock markets just stinks.

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In the past five years, the correlation between monthly returns on the FTSE All-Share index and monthly returns on the FTSE world index, excluding the UK in sterling terms, has been 0.95. This means that the All-Share moves almost in lock step with overseas markets.

What’s more, during this time, overseas markets have been more volatile than the All-Share. They’ve had a standard deviation of monthly returns of 5.65, against 5.15 for the All-Share. As a result, investing overseas during the past five years would have exposed you to greater risk than investing in the UK alone.

And there’s no reason to suppose that things will change. In fact, quite the opposite. The correlation between the UK and overseas market has been trending upwards for years. This is partly because foreign investors have increasingly bought UK stocks, and partly because UK companies are more and more exposed to the global economy – let’s face it, are BP, GlaxoSmithKline or Vodafone really UK companies in any important sense?

A consequence of globalisation, then, is that UK stocks are highly sensitive to the US economy. Since January 1997, the correlation between annual changes in US industrial production and annual returns on the All-Share index has been a hefty 0.68. So as a UK investor, you’re heavily exposed to the global economy before you’ve spent a penny on foreign stocks. Do you really want to take on even more exposure?

You might reply that you don’t invest overseas in order to spread risk, but to get higher returns.

Sadly, this hasn’t happened in the past five years – the All-Share has outperformed the rest of the world in sterling terms.

Of course, there have been occasions when overseas markets outperformed the UK. But even these do not provide a clear-cut case for investing overseas. Our chart, equity and currency moves (below) shows why. It shows that, quite often, rises in the S&P 500 relative to the All-Share are offset by falls in the dollar.

For example, take the two years to June 2004. The S&P outperformed the All-Share by almost 15 percentage points then. But the dollar fell 20 per cent, more than wiping out this superior performance.

This is no accident. It’s just common sense. Imagine global investors believed that, say, the S&P was about to outperform the All-Share. Why, then, would anyone prefer to hold UK stocks to US ones?

It could only be because they expect the dollar to fall, to offset relative stock-market gains.

So common sense tells us that expected relative gains on overseas equities should be offset by expected losses on the currency. Economists call this uncovered equity return parity.

Of course, expectations are sometimes wrong. For example, in the late 1990s, US equities outperformed UK ones, and the dollar rose, too. This happened because of some combination of pleasant surprises to US economic growth, and increased appetite for US assets generally, as a result of the technology bubble.

However, you could only have made money from this if you were smarter than the average investor, and so could have spotted these surprises before the others.

Which raises the question: are you really cleverer than the average global investor? If you’re not, buying overseas equities is not for you.

Or is it? There is, despite all this, a strong case for investing in overseas equities. Quite simply, this is what a passive investor – an index-tracker – should do.

And the argument for investing in this manner is strong. It goes like this: if you know no more than the average investor, you should hold the same portfolio as the average investor.

But the average investor is not an Englishman holding an All-Share tracker. It’s a worldwide investor holding the global market. So if we’re being strictly logical, therefore, everyone who holds an All-Share tracker fund should really hold a global tracker instead.

Given the correlation between the global market and All-Share, though – and uncovered equity return parity – this difference is small for practical purposes.

Still, there’s another argument for investing more adventurously overseas. It’s that stock markets in poor countries should, in theory, offer higher returns.

This is not because poor countries tend to grow faster than rich ones, and economic growth raises share prices. A moment’s thought will reveal this to be gibberish.

For one thing, if investors see economic growth coming, they will bid up share prices in anticipation. So it’s only unanticipated growth that raises prices.

And even this might not move prices. Economic growth need not benefit existing quoted companies. The fruits of growth might instead flow to workers, or bosses, or private firms, or companies that don’t yet exist.

For these reasons, there’s little correlation, even over long periods, between gross domestic product (GDP) growth and stock-market performance. For example, since 1998, the US economy has grown faster than Germany’s, but Germany’s stock market has outperformed the US’s. And China’s economy has growth faster than France’s, but France’s stock market has performed better.

Instead, there’s a more profound reason why poor countries should see good stock-market performance.

This is to do with the marginal utility of consumption. Put it this way: why bother buying a share rather than, say, a new car? Obviously, it’s because the benefit that you expect to get from the share – its expected returns – exceeds the benefit that you expect from a new car.

Then, economic rationality says that you should keep buying shares until the marginal benefit of them just equals the cost. In this case, this cost is the car that you could have bought.

Now, what if you already own two luxury cars that you hardly ever drive? In this case, the cost of your shares would be very low, because their marginal cost is low – you just don’t need another motor. You would, therefore, be content to buy shares even when expected returns on them were low, because their cost – the extra car foregone – is low.

But what if you depended on an unreliable, leaky old banger? In this case, the marginal utility of a new car would be very high. So you would only buy shares instead of the car if expected returns on them were very high.

The message, then, is clear. When the marginal utility of consumption is high, so, too, should be expected returns. And the marginal utility of consumption is highest in poor countries – they are the ones with the knackered Beetles, not the new BMWs.

In fact, expected returns on equities should be highest in the poorest countries only because investors there have to make bigger sacrifices to buy shares, and so need higher returns to reward them for doing so.

Evidence from really deep emerging markets suggests that there’s something in this. In the past 10 years, the Slovenian market has returned 519 per cent, the Jamaican market 477 per cent, the Ivory Coast market 382 per cent and the Botswana market 1,300 per cent. What? You didn’t know Botswana had a stock market?

That’s the point. Poor countries only have stellar stock returns if the marginal investor – the one who, in effect, sets prices – is a domestic investor. That’s because it’s only the domestic investor who has the high marginal utility of consumption.

Once a stock market attracts the attention of the multitude of Western fund managers, the latter becomes the marginal investor. And because their marginal utility of consumption is low, so, too, will be expected returns.

As a result, the more familiar a stock market seems to you, the lower its returns will be.

Of course, not all poor countries’ stock markets do well. Markets in Bulgaria, Ghana and Bangladesh, to name but three, have fallen over the past 10 years.

But herein lies another benefit of deep emerging markets. Because these are not well integrated into the global economy, they have low correlations with developed markets.

So they do offer us a way of spreading risk.

For example, the Bangladeshi market collapsed in 1997 when the FTSE All-Share did well. And it rose in 2000 when the All-Share fell. Similarly, the Bulgarian market slumped in 1999 when Footsie rose, and rose in 2002 when Footsie fell.

So there is a strong theoretical case for investing in deep emerging markets and really poor countries. Unlike developed overseas markets, they offer both genuine high returns and risks that can be spread.

How do you invest in them? With enormous difficulty. And herein lies the paradox of overseas investing. Where it’s easy, it’s pointless. And where it’s desirable, it’s impossible.

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