Home-country bias in Robo-advice

This article was originally published on AltFi.com.

Home country bias is important to understand for followers of Robo-Advice as it is prevalent in pretty much every proposition we've looked at. It would indicate to believers in efficient markets that a lot of portfolios constructed for the mass market are sub-optimal.

Here's a quick guide to Home Country Bias

Home country bias refers to investor’s consistent and globally observed preference for investing more in their home country than financial theory would predict. This is despite professional risk managers being aware of the benefits of diversified international portfolios. Here are some of the factors or possible explanations behind this effect.

Familiarity - End users often feel more comfortable with their home market and allocate investments accordingly, even if this is non-optimal in a risk return framework. A case of less stress but less return.

Governance - Investors will often feel comfortable with their own economic system and the governance standards within their domestic market, but be wary of the unknown. In particular  investors worry about differing approaches to governance in emerging markets. A large part of this shortfall is thought to be due to perceived risk around accounting standards, property rights and shareholder protections in developing nations. Investors can mitigate some of their worries about lower standards of governance by selecting multi-national firms or purchasing stocks with local listings.

Exposure to Multi-nationals - Multinational companies sell and consume goods and services around the globe, which means that they provide exposure beyond the domestic economy. For many of the world’s largest firms the majority of both revenues and costs are non-domestic, and the domicile of stock listing is almost an historical accident rather than an economic reality. Investors may feel that through exposure to the world’s largest corporations, they are able to gain access to international investment opportunities and risk premia, but at low cost and more familiar standards of corporate governance. For many advisors/trustees the existence of Multi-nationals can substitute for the need to gain in-house emerging market or international specialists.

Costs -  For many investors with pre-existing relationships within their own markets, the cost of forming new relationships and developing new skill sets is perceived to outweigh the benefit. In addition in the new era of transparency and full disclosure of charges, investing in foreign and esoteric markets that have both higher transaction costs and less liquidity is unattractive as these charges will be observable on Total Expense Ratio’s TERs. High TERs could then make a firms offering look uneconomic. For an investor solely focused on gaining exposure to risk assets at the lowest possible cost, many international markets offer; higher transaction charges; higher costs due to slippage; higher asset management charges; greater monitoring costs in addition to poorer liquidity. It’s not surprising that this kind of investor will likely stay at home.

Conversely, those Investors based in costly or generally illiquid markets could benefit significantly from increased global diversification because their investments would be shifted into lower cost regimes. For example, for all non-US investors a large proportion of assets would be directed towards the US stock market, which has the most liquid and lowest-costs available globally.

Currency - Exposure to assets denominated in foreign currencies can add another risk exposure for those straying away from their home markets. Although much of the volatility in foreign investing can be attributed to exchange-rate fluctuations, and can be negatively correlated with domestic assets, the presence of an extra risk factor can be off putting. For retail or non-professional investors the cost of exchanging currencies can also add significantly to transaction costs, far outweighing any marginal benefit from diversification.