ETF transparency helps investors overcome the risks of home country bias

By Lori Bamber

If you’re looking for an indicator of the world’s perception of Canada’s economy, you might consider the exchange value of our currency, hovering around 75 cents U.S.

But if their equity portfolios are an accurate gauge, Canadians are much more enthusiastic about the future performance of the TSX. “The average investor has some 60 per cent of their assets invested in Canadian equities – and yet Canada’s weight in the global equity market is around four per cent,” says Pat Dunwoody, executive director of the Canadian ETF Association.

While this concentration has paid dividends in the past as commodity prices climbed, it is also a significant – and completely avoidable – risk factor. “Home country bias is a hazard to long-term returns,” says Reg Jackson, a portfolio manager with the JMRD Wealth Management Team at National Bank Financial. “Regardless of the country in question, too much of anything can be detrimental.”

Intensifying the risks of geographic overweighting is the composition of the Canadian market, heavily concentrated in energy, financial and materials and underweight in all other sectors, says Dunwoody. “This has sometimes been profitable for investors, but it has become an issue with energy and mining – and it could become much more of an issue in the future.”

Canadian investors are already leaving potential returns on the table as U.S. and some European markets outperform, along with several asset classes that are inadequately represented on the TSX, notes Jackson.

Part of the challenge is that many Canadian investors think their portfolios are far more diversified than they really are, because they own a variety of mutual funds. “It looks like diversification, but it is so common to own a number of mutual funds that own the same companies,” he explains.

In fact, Jackson recently analyzed seven Canadian mutual funds spread across a variety of management companies, and found that the top 10 stocks in each of those seven mutual funds were the same.

“This compounds the home bias issue,” says Dunwoody. “Rather than being adequately diversified geographically and by sector, you may be investing in the same stocks over and over again.”

ETFs can be an important antidote to home country bias, in part because of their transparency, she says. “If you’re investing in an S&P 500 ETF, you know exactly what you’re buying. An investor is not going to go out and buy seven S&P 500 ETFs, because they know that the composition of the portfolios is the same.”

She adds that, in addition to being an effective diversification tool, the low costs that ETFs are most well known for make it possible for investors to retain more of the market’s returns, and their tax efficiency is a valuable feature for those who have maxed out their RRSP and TFSA room.

Canadian-based ETFs that reflect international markets can also help investors avoid currency risk while diversifying geographically, one of the factors that can otherwise contribute to home country bias.

Effective investing starts with a plan, and ETFs are excellent building blocks with which to execute that plan, says Jackson. “The role of an advisor or portfolio manager (PM) is to work with a client to come up with an appropriate plan, starting with a personalized investment policy statement. From that comes an asset allocation strategy. Once that is agreed upon, it is up to the advisor or PM to fill in the blanks – with ETFs, we know exactly what we own at all times.

“There is no holdings overlap, and it is a low-cost, tax-efficient approach. It is easy to rebalance periodically to keep us close to the target weighting.”

Home country bias leads to poor diversification and higher risk because “investors like to stick with the comfortable and familiar,” say Dunwoody. “They may believe that investing abroad exposes them to a substantial amount of additional risk.”

That belief can overshadow the fact that adequate diversification is the single most efficient risk management tool, she stresses. “You obviously don’t want to take your portfolio from 60 per cent to four per cent Canadian equity – start by talking to your advisor, perhaps about countries that may not be resource-heavy, for example.

“The key is to diversify your portfolio in a way that balances the risks of the Canadian market.”

Former Chatelaine Magazine Money Expert and radio host Lori Bamber has authored seven books on personal finance and investment. Her work has appeared in The Globe and Mail, BCBusiness, Alberta Venture and other publications.

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