Heavy exposure to domestic assets divides US advisers
US financial advisers are divided over how heavily their clients should be exposed to domestic securities, as investors risk missing out on benefiting from fast-growing foreign economies.
Of the total funds looked after by advisers in the FT 300 list, 72 per cent are held in products that invest in US equities and fixed income. Since the US represents around 50 per cent of the global equity market and around 40 per cent of the global bond market, some investment professionals have warned of the over-reliance on domestic securities.
Home country bias is prevalent in other markets, according to a report published by Vanguard, the asset manager, in December. For example, while the UK represents around 7 per cent of the global equity market, local investors dedicate 26 per cent of their equity allocations to UK stocks. Japan represents 7 per cent of the global equity market and local investors have around 55 per cent of their equity allocations in Japanese shares.
“Investors are more comfortable with what they know well,” says David Cariani, chief investment officer at Reilly Financial Advisors, adding that wealth mangers and investors in the US “prefer to avoid countries with less rule of law and minimal investor protections”. He says there are two other main reasons US investors’ portfolios are overweight in US assets: the role of the dollar and investment performance.
The currency that investments are denominated in is a crucial factor because it affects an investment portfolio’s net returns. Mr Cariani says that the expenses and liabilities of US investors are in US dollars, “so it makes sense” to avoid adding too much risk from exchange rate volatility, which is a byproduct of investing in foreign markets.
On performance, Mr Cariani says US assets have generally been more appealing over the long term. He points to the 6.7 per cent annual return of the US S&P 500 index over the 15 years to December, compared to the 5.9 per cent return for the MSCI All Country World Index ex-US over the same period.
John Frownfelter, managing director of investment products at SEI Investments, stresses that balance is needed in an investment portfolio. “By focusing assets in one country, even a large one like the US, you’re foregoing potential diversification benefits associated with owning a broader set of securities,” he says.
Predictions that the US share of global output will decline despite it being the world’s leading economy are sharpening the debate about the correct weighting of investment funds to domestic assets.
A company’s domicile, however, does not necessarily indicate the geographic diversification of its business, according to John Gilbert, director of research at Bradley, Foster & Sargent, an FT 300 adviser. “Many US firms, particularly the larger ones, have significant operations outside the US, and those foreign profits may exceed those earned in the US,” he says.
Mr Cariani of Reilly, also on the FT 300 list, notes that Microsoft derives just 50 per cent of sales in the US, while Qualcomm generates nearly all its sales from overseas. On the flipside, he says that Taiwan Semiconductor, a Taiwanese company, derives two-thirds of its sales in the US.
“The S&P 500 generates roughly half of its sales overseas,” he says, adding that it is possible to build a portfolio that is 50 per cent exposed to US markets and 50 per cent to international markets while investing in only US securities.
However, he points out that not all sectors are represented equally. For example, utilities are physically constrained to operating locally, so it would be necessary to add foreign investments to gain utility exposure globally, he says. “The result is that construction of a globally diversified portfolio is now more complicated than ever, requiring managers to dig deeper into the details to understand exactly which exposures they are taking on.”
Mr Frownfelter says there are several advantages to increasing allocations to non-US assets, including broader diversification and less exposure to “idiosyncratic US risks”, such as the uncertainty surrounding President Donald Trump’s administration, its tax policy and geopolitical developments.
The main disadvantage of increased diversification is the potential for investor discomfort, Mr Frownfelter says.
“There’s a tendency for US investors to psychologically benchmark their investments against US indices even if their actual portfolios are globally diversified,” he says, citing the Dow Jones Industrial Average, S&P 500 and the Barclays Aggregate Bond Index as the benchmarks US investors typically use.
“Inevitably, there will be periods where US assets outperform non-US assets dramatically, creating the potential for client dissatisfaction if they can’t be encouraged to evaluate their portfolios’ performance in a more appropriate way.”