Brexit and the risks of home bias

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Jean-Maurice Ladure

Jean-Maurice Ladure
Executive Director, Head of Equity Solutions Research, EMEA

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Brexit and the risks of home bias


From credit crunch to liquidity crunch: managing liquidity

 

Every so often, a country can be hit by a negative event — a tidal wave, a terrorist attack, a political uproar. Whether wrought by nature or humans, such outliers can lead to lower economic prospects and thus weaker domestic stock-market performance.  

Uncertainty over Brexit is a case in point. The prospect of the U.K. leaving the European Union contributed to another steep decline in the MSCI United Kingdom Index in 2018, wiping out any capital appreciation since the start of the century — the price index fell 12.6%, while MSCI World declined 4.9% in GBP terms. This example highlights the potential risks posed to investors with heavy exposure to their domestic market as a result of home bias.

 

The Brexit downturn in perspective
MSCI UK - PRICE INDEX

 

U.K. institutional and retail investors, respectively, held more than 25% and 45% of their stock holdings in U.K. companies, according to industry research.1 To illustrate U.K. investors’ relative concentration in their home market, U.K. stocks made up only 5.2% of the free-float market capitalization of the MSCI ACWI Index as of the end of December 2018.

Investors’ tendency to cluster their holdings in domestic markets may expose portfolios to higher volatility. Our research suggests that greater international diversification could have helped reduce risk exposure in those U.K. investment portfolios tilted toward domestic stocks, over both the short and long term.2

Historical U.K. equity returns have lagged those of global equity indexes. Accounting for dividends, the MSCI United Kingdom Index showed an average of 3.6% annual returns (in GBP) for calendar years 2000 through 2018, but still trailed global equity markets: Both the MSCI World and ACWI indexes returned 5.2% annually over the same years. In fact, the U.K. stock market has underperformed global markets over the 1-, 3-, 5-, 10- and 20-year periods ending Dec. 31, 2018.

 

UK stocks’ underperformance vs. global indexes  
Net Total Return Performance (%)
  MSCI UK MSCI World MSCI World IMI MSCI ACWI IMI
1 Yr -8.8 -3.0 -3.8 -4.5
3 Yr 6.7 11.6 11.6 11.8
5 Yr 3.6 10.2 10.1 9.8
10 Yr 8.1 11.0 11.3 11.1
20 Yr 4.2 5.8 6.3 6.4

Net returns in GBP for the period 31-Dec-1998 to 31-Dec-2018  

 

British investors with a significant home bias to the U.K. stock market might have benefited by diversifying their equity investments more internationally over these years.

 

Origins of home bias  

Home bias perhaps stems from the investor perception that international equity markets are difficult to access or pose unique risks (in particular, currency risk). But market accessibility has generally improved, and the U.K. market poses its own risks. Indexes such as the MSCI ACWI Index are designed to include only those countries and stocks that provide international institutional investors with good liquidity and accessibility.

The U.K. stock market is admittedly quite international: A number of global companies have chosen to list in London, and only 25% of U.K.-listed companies’ aggregated revenues are domestic, as measured by the MSCI Economic Exposure Index methodology. However, the U.K. equity market is highly concentrated in a few companies and poses significant asset-specific risk. The MSCI United Kingdom Index, which captures large- and mid-cap stocks, currently has only 96 constituents, with the largest five companies representing 30% of the weight of the index. As a consequence of this high concentration, idiosyncratic risk accounted for 22% of the index’s total forecast risk. The picture remains very similar if you consider the MSCI United Kingdom Investable Market Index (IMI), which captures a large number of smaller companies among its 364 components. The MSCI ACWI IMI, by contrast, contains 8,725 constituents and is designed to represent a broader investable opportunity set of global equities. Its five largest companies represent 6% of the weight of the index, with asset selection contributing just 6% to the total risk for the index.

 

Higher company-specific risk with UK home bias  
Concentration Metrics
  Number of
  Securities
Weight of top 5
  Sec. (%)
Idiosyncratic
  Risk*
Total Risk* Idiosyncratic/total
  Risk Ratio*
MSCI UK 96 29.9% 2.6% 12.0% 22%
MSCI UK IMI 364 25.3% 2.2% 12.0% 19%
MSCI World IMI 6013 6.8% 0.9% 13.1% 7%
MSCI ACWI IMI 8725 6.0% 0.8% 13.0% 6%

* Ex-ante annualized volatility estimate in GBP as of Dec. 31, 2018, based off of BARRA Global Equity Model for Long Term Investors(GEMLT)

 

Home bias has led to sector and factor bias  

Domestic bias also led to significant sector and factor bets vs. the MSCI ACWI IMI. In terms of sectors, the U.K. market will provide very little exposure to information technology (less than 1% in the MSCI United Kingdom Index vs. 15% of ACWI IMI), while overweighting energy and consumer staples.As for factors, using MSCI FaCS we found the U.K. index displayed a sizable overweight toward low-volatility stocks.

 

UK INDEX SHOWS OVERWEIGHT TOWARD LOW VOL STOCKS

We compare average and turmoil correlation between credit spread and bid-ask spread moves in three different markets. Long-time averages are calculated based on daily returns throughout 2018. Turmoil correlation is measured in May for Italy and in August for Turkey.
 

Finally, portfolio theory suggests that institutional investors could benefit from significant risk reduction and return enhancement by venturing out of their domestic markets and capturing the opportunities offered by global equities. With globalization, regional equity markets have converged and seen their correlations rise in recent decades, but individual domestic markets have nonetheless continued to display significant regional variance in their risk and return metrics. Over the past 15 years, a GBP investor in the U.K. market would have benefited by investing in other developed markets, emerging markets and small caps. Over this period, the MSCI United Kingdom Index significantly underperformed MSCI ACWI IMI (6.8% vs. 9.5% annual returns), with a very similar level of volatility (12.6% vs. 13.0%). And ACWI IMI would have offered slightly better downside protection — with, for example, a maximum drawdown of 39.1% for MSCI ACWI IMI, against 45.3% for the MSCI United Kingdom Index.

 
Key risk and return metrics show UK-global variance  
 
  MSCI UK MSCI UK IMI MSCI World IMI MSCI ACWI IMI
Risk/Return Trade-off
Total Return* (%) 6.8 7.3 9.5 9.5
Total Risk (%) 12.6 12.6 12.7 13.0
Return/Risk 0.54 0.58 0.75 0.73
Downside Risk Metrics
Annualized Downside Deviation (%) 8.4 8.4 8.2 8.4
VaR @ 95% -6.3 -6.0 -6.1 -6.0
Max Drawdown (%) 45.3 45.6 38.5 39.1

Period: 31-Dec-2003 to 30-Nov-2008  

*Net returns annualized in GBP  

 

Several large and leading U.K. pension plans have already adopted a more global approach in their equity asset allocation, breaking the regional and domestic/international divide. Other U.K. investors may choose to similarly rethink their equity investment process.

 

 

1 Mercer. (2017) “European Asset Allocation Report.” PIMFA. “Private Investor Indices – Current Asset Allocation.”

2 Melas, D. and Ruban O. (2009). “International Diversification from a UK Perspective.” MSCI Research Insight.

 

 

Further Reading

Is it time to change your number?

Keeping Indexes Investable in Evolving Markets

MSCI ACWI Index

MSCI United Kingdom Index