Regardless of where they live, investors have a significant opportunity to diversify their equity portfolio outside of their home market.
Despite the opportunity, investors typically maintain a significant “home bias”, I.E., higher allocations to their home country than the market capitalisation weight these represent in a global equity index.
Australian investors have tended to build portfolios that are highly concentrated in the domestic equity market. The Australian market has on average represented roughly only three percent of the MSCI World market cap weighted index.
This piece examines how a portfolio predominantly allocated to Australian equities (proxied by the MSCI Australia Index) stands to benefit from a greater breadth of global opportunities (proxied by the MSCI World Index).
Global Sector Diversification
Global equities provide exposure to a diverse range of countries, sectors and industries which can serve as a hedge against specific country, sector or industry risk. Australian equities are highly concentrated at both the sector and individual security level.
The Financials and Materials sectors alone constitute nearly 60% of the Australian equity market compared with 20% globally (Chart 1). Diversifying exposure globally provides investors the opportunity to participate in regional markets which are performing differently, thereby further diversifying sources of risk and return.
Chart 1: Sector Concentration MSCI Australia vs MSCI World
Source: Bloomberg, based on GICS classification as of May 31,2019.
Australia's Concentration Risk
The Australian economy and listed equity market are dominated by a few sectors such as Financials and Materials which constitute nearly 60% of the index compared with a 20% participation in the global market. These sectors are heavily represented in the top holdings within the MSCI Australia Index, with the largest top 10 stocks comprising over 50% of the Index.
Furthermore, the top five stocks comprise more than a third of the index while the bottom third of the index is comprised of 55 stocks (see chart 2).
Chart 2: Stock Concentration in MSCI Australia
Source: Bloomberg, June 2019
Drawdown Benefits of International Diversification
Anchoring stock selection and portfolio construction purely to the Australian equity index increases overall risk exposure. By leaving investors reliant on only a handful of return drivers, Australian indices expose investors to higher volatility and more frequent drawdowns than better diversified global indices.
Due to the concentrated nature of the Australian equity market, over the trailing 10-year period, Australian equities have realised over 30% more volatility and on average over 60% greater drawdowns (Chart 3).
Chart 3: Trailing 10-year Average Drawdown Risk
Source: eVestment, monthly returns. 10-year trailing period as of May 31, 2019.
An allocation to global equities would have significantly improved both risk and return over the trailing 10-year period (as shown in Chart 4).
A portfolio comprised of 75% Global Equities and 25% Australian equities would have realised 30% less risk over this period compared to a portfolio comprised of 100% Australian equities.
Chart 4: 10-year Risk vs Return Portfolio Characteristics
Performance Cost of Home Bias
In addition to the increase in volatility in drawdowns experienced by the home bias investor, there has been substantial opportunity cost associated with lack of global index exposure.
Even in those calendar years where the MSCI Australia Index has outpaced the MSCI World Index based on total return, the vast majority of top performing stocks were based outside of Australia, underscoring the opportunity a global manager has to potentially add additional alpha to a purely (or largely) domestic Australia portfolio.
The chart below highlights the opportunity cost of foregoing exposure to the global equity universe. In all years since 2009, nearly 100% of the top 50 performing stocks in the MSCI World Index were domiciled outside of the Australian market.
Chart 5: Percentage of Top 50 Stocks that are Non-Australian
Source: QS Investors, Bloomberg. Indices: MSCI Australia, MSCI World ex Australia.
Global Equities & The Opportunity for Alpha
The scope and diversity of the global equity market makes fertile ground for active managers. Data on Alpha by international managers bears this out.
The below chart shows that both the median and top quartile Active managers earned significantly more Alpha for their clients as compared with those constrained to the U.S. market.
Chart 6: Global vs Domestic Manager 10 Year Excess Returns
Source: As of December 31, 2018 over 10 year trailing returns. Source: S&P 500 Index, MSCI ACWI Index. Based on Global Large Cap Core eVestmentPeer Group and US Large Cap Core eVestmentPeer group. ¹Median fee 49bps based on eVestmentLarge Cap Core Peer Median Group for SMA assuming $100M mandate. ²Median fee 59bps based on eVestmentGlobal Large Cap Core Peer Median Group for SMA assuming $100M mandate.
The global income drought means investors no longer have the luxury of staying home. With Australia comprising only 2% of global equity markets, investors would be foolish to constrain themselves to the domestic market alone.
That said, all investing demands diligence; it must be done right or not at all. Thus, a consistent and thoughtful approach is required. QS Investors takes pride in providing clients a systematic and rigorous process with which to engage the global equity market.
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