Beating the benchmark

Tom Goodwin of FTSE Russell discusses the challenge of overcoming home bias and offers his insight on where the market might be headed

Beating the benchmark

It’s a common criticism of Canadian investors that home bias holds back their ability to generate alpha in a portfolio. Economist Tom Goodwin believes that reputation isn’t entirely unfounded, but Canada isn’t alone in this respect.

“There’s home bias in every country – it’s comfortable for investors, and it keeps money at home, employing local people,” he says. “It is probably less pronounced in the US, but that’s only because it’s a little bit over half the global equity market. So if you have 80% US, you are only 30% biased, whereas if you have 80% in Canada, you are 77% biased.”

As senior research director for Londonbased stock index provider FTSE Russell, Goodwin is an expert in the fields of indexing, asset allocation, factor allocation, forecasting, performance measurement and risk budgeting. As such, he is well placed to comment on the topic of home bias, which was the subject of his recent presentation at the Exchange Traded Forum in Toronto in April.

“If you’re investing in your own country’s companies, there isn’t as much currency risk, but a home bias certainly drags on volatility and drawdown measures,” he says. “Depending on the time period, if Canada is outperforming the rest of the world, it might be better to be more in Canada, but generally the risk will be higher if you are concentrated in Canadian equities.”

Being overweight on Canadian stocks also means being tied to a limited number of sectors. The dividends that go along with the Big Six banks will always be an important part of any portfolio in Canada, but Goodwin believes that over-reliance on the Canadian economy’s other main sectors is usually asking for trouble.

“Besides the fact that [Canada] is a small part of the global market, there’s also the fact that it is concentrated in three industries – energy, materials and financials,” he says. “If you want sectors like healthcare and IT, which are huge elsewhere, they are almost nonexistent in Canada.”

Where to diversify
In looking for geographical diversification, Goodwin encourages advisors to choose investments that fit with clients’ portfolio objectives and risk tolerance.

“It is the US, it is developed markets, and if you want to accept a little more risk, you go with emerging markets,” he says. “There’s a huge world out there, and the benefits of diversification are very clear in going from a 60% to 70% concentration in Canada in a portfolio to something like 20% to 30%.”

Emerging market exposure could mean looking to China, which traditionally has been a hard nut to crack for investors and the major Western asset managers. That is changing, though, now that Beijing has committed to financial reforms that will open up the world’s most populous country to outside investment.

“Indexing and the ETFs tracking indexes are really making strides right now in the Chinese market,” Goodwin says. “I think we will see more and more interesting products come out around China.”

The emergence of exchange-traded funds in recent years has been a real game-changer for diversification. Aside from the lower fees the investment vehicle is best known for, Goodwin sees a lot of other positives to using ETFs.

“With ETFs versus mutual funds on the Russell 2000, we have seen a consistent drawdown in mutual funds tracking the Russell 2000 and an increase in ETFs doing the same,” he says. “The ETF vehicle has become so much more popular, and one of the reasons is that with a lot of ETFs, there is an active securities lending trade that goes on. That means someone who owns an ETF can essentially loan it out and get some income while they are still holding onto it.”

It’s not surprising, then, that the industry’s heavy hitters are the ones leading this trend, including the largest of them all: BlackRock.

“I recently saw a figure that 60% of ETF issuances are using securities lending to enhance income and pass it onto the end investor,” Goodwin says. “One example is IWM, which is an iShares ETF that tracks the Russell 2000 – they have made enough on sec lending income to actually pay back their basis points to the holders of the ETF over the last year or two.”

Cycle dynamics
Having spent the last 22 years analysing market trends and the peaks and valleys of various economic cycles, Goodwin is uniquely qualified to discuss the current state of the market. A flattening yield curve in the US is certainly cause for concern, given its documented ability to foreshadow a recession. However, there’s another school of thought that believes the unprecedented fiscal stimulus after the financial crisis makes this current period different from previous economic cycles.

In Goodwin’s opinion, there are reasons for caution, but that doesn’t mean a massive correction is inevitable anytime soon.

“I recently did some work on the Russell 2000, comparing this particular cycle to some other cycles going back to the ’70s – this cycle still has room to run,” he says. “It’s getting late, but it’s not well past its sell-by date, at least not historically speaking.”

That can all change pretty quickly, however, as the events of 2008 attest. After all, there weren’t many economists predicting a worldwide collapse in 2007. Although Goodwin believes a repeat of the financial crisis remains unlikely, he nonetheless advises a measured approach when it comes to downside risk.

“There is a worry about inflation, which may trigger the Federal Reserve to be much more aggressive,” he says. “Every time an inflation statistic is published, it gets a little bit higher than expected, so you can expect a little bump in the market.”