How does home bias impact Canadian investment funds?

Report examines risk of home bias in global equity and global fixed income funds, and impact on historical performance

How does home bias impact Canadian investment funds?

In Canada and across the world, home bias is a notoriously tricky behavioural problem: by allocating more toward the stocks they know and love, investors can increase the amount of concentration risk towards particular sectors and styles in their portfolios.

Some Canadian investors may want to offset that risk by investing in global bond and equity funds. It’s not a perfect fix as their underlying portfolios still have a domestic bias relative to global indexes – but a new report from Morningstar Canada suggests managers have made some progress.

Among many key takeaways, the report found that over the last 10 years up to September 2023, global equity and global small/mid-cap equity funds in Canada saw a decline in home bias.

“There's a lot more competition now in the space than there was 10 years ago. We have a lot more global equity funds in Canada, and probably a lot that are filling that space for being a truly global equity fund,” explains Michael Dobson, associate manager research analyst at Morningstar Canada.

Dobson suspects there’s some FOMO at play in the drift away from home bias in these global categories. Over the last 10 years, he says Canada has been an underperformer relative to other markets – particularly the US – which could push some managers to increase their allocations toward other markets.

Looking at the Morningstar Global Markets Index, which captures most global stocks, he says Canada’s representation fell by more than 20%. While that drop equates to a decline of merely 0.8 percentage points, Dobson says it speaks to how Canada’s underperformance against the rest of the world has been a drag on its representation in the global markets.

The study also found that among global equity funds, those with a fund-of-funds structure have a much larger degree of home bias than conventional funds that hold securities directly. That disparity, according to the report, points to a “fundamental difference in portfolio management between those that manage funds of funds and those that focus more on security selection.”

According to Dobson, searching for global equity funds on Morningstar Direct and ranking them by how much weight they have in Canadian equities reveals many of them map onto the all-equity side of the allocation spectrum, with the funds technically falling under the global equity category.

“Vanguard and DFA did research around how much they would want [to allocate] in Canada, and both hold around 30% of their equity in Canada. It just maps across to their all-equity fund,” he says. “A balanced fund holding 30% of its equity in Canada might not stand out. But when you expand that and put it into global equity, that 30% in Canada looks like an outlier. And you see that in the tail ends of these very large allocation series.”

On the fixed-income side, the report took a look at home bias across three categories: global fixed income, multi-sector fixed income, and global corporate fixed-income funds. Within the global fixed income category, it found that the average fund-of-fund experienced a sharp 38-percentage-point drop-off in Canadian bond exposure over the 10 years ended in September 2023.

“A lot more global fixed-income funds have come to market over the last 10 years,” Dobson says. “For investors looking to actually move away from a Canadian bond fund, the number of options has grown significantly.”

Looking at the past 10-year record of performance for global bond funds, Dobson says a home bias toward Canadian bonds didn’t prove to be either a setback or a benefit. Based on returns alone, he says currency-hedged global bond funds and unhedged funds didn’t show a material difference in performance, though the hedged versions showed far less volatility than their unhedged counterparts.

“That’s consistent with what we talk about with investment managers,” Dobson says. “It’s almost a default requirement to hedge your global bond exposure, because you don’t want the currency risk associated with investing in other countries.”

On the equity side, the past 10 years have seen strong performance for global equities overall, especially the growth and tech-heavy US. But the same couldn’t be said for the Canadian equity market as its bias toward energy and value dragged on performance. The upshot, Dobson says, is that someone who had a home bias toward Canada in their equity portfolios would have struggled to keep up with the rest of the world.

“At a high level, Canada could be a poor country to overweight,” Dobson says. “If you look at how sector-concentrated the Morningstar Canada index is, you have financials and energy making up roughly half of the benchmark. … It goes to show how investors should pay attention to the geographical exposure in their own portfolios and in the funds they invest in.”