How should residents of smaller economies allocate their portfolio between domestic and foreign assets?

Question

Investment advice is often written from the perspective of a large domestic economy, where global effects have less impact. I live in Australia, where GDP is $1.13 trillion and our stock exchange has a market capitalisation of $1.6 trillion — around ¹/₂₀^th of the United States'. Suppose I want to allocate 60% of my assets to stocks, 30% to bonds, and 10% to cash. How should I divide the allocations between Australian and foreign assets?

Most Australian superannuation funds are weighted in favour of Australian shares. For example, AustralianSuper's default portfolio currently allocates 23% to Australian shares and 35% to international shares. Individual investors are also less likely to purchase foreign stocks because of higher transaction costs and unwanted currency risk.

However, mutual funds denominated in Australian dollars such as the Vanguard International Shares Index Fund are available. This fund tracks the MSCI World (ex Australia) index:

Since Australia is taken out of the index, I still don't know how to decide on the weighting to give to Australian assets in my own portfolio. Currency risk and higher transaction fees are good reasons for a strong bias in favour of domestic assets. I'm not a forex trader, so it's probably pointless for me to hold any foreign bonds or cash.

Conversely, if I want to allocate 60% of my portfolio to diversified stock holdings, why should I have any bias in favour of my local economy? Should the composition of my stock portfolio track the global economy, like the MSCI World index?

Answer 1

why should I have any bias in favour of my local economy?

The main reason is because your expenses are in the local currency.

If you are planning on spending most of your money on foreign travel, that's one thing. But for most of us, the bulk of our expenses are incurred locally. So it makes sense for us to invest in things where the investment return is local.

You might argue that you can always exchange foreign results into local currency, and that's true. But then you have two risks. One risk you'll have anywhere: your investments may go down. The other risk with a foreign investment is that the currency may lose value relative to your currency. If that happens, even a good performing investment can go down in terms of what it can return to you. That fund denominated in your currency is really doing these conversions behind the scenes.

Unless the bulk of your purchases are from imports and have prices that fluctuate with your currency, you will probably be better off in local investments. As a rough rule of thumb, your country's import percentage is a good estimate of how much you should invest globally. That looks to be about 20% for Australia. So consider something like 50% local stocks, 20% local bonds, 15% foreign stocks, 5% foreign bonds, and 10% local cash. That will insulate you a bit from a weak local currency while not leaving you out to dry with a strong local currency.

It's possible that your particular expenses might be more (or less) vulnerable to foreign price fluctuations than the typical. But hopefully this gives you a starting point until you can come up with a way of estimating your personal vulnerability.

Answer 2

We face the same issue here in Switzerland. My background: Institutional investment management, currency risk management. My thoughs are:

Home Bias is the core concept of your quesiton. You will find many research papers on this topic. The main problems with a high home bias is that the investment universe in your small local investment market is usually geared toward your coutries large corporations.

Lack of diversification: In your case: the ASX top 4 are all financials, actually banks, making up almost 25% of the index. I would expect the bond market to be similarly concentrated but I dont know. In a portfolio context, this is certainly a negative.

Liquidity: A smaller economy obviously has less large corporations when compared globally (check wikipedia / List_of_public_corporations_by_market_capitalization) thereby offering lower liquidity and a smaller investment universe.

Currency Risk: I like your point on not taking a stance on FX. This simplifies the task to find a hedge ratio that minimises portfolio volatility when investing internationally and dealing with currencies. For equities, you would usually find that a hedge ratio anywhere from 0-30% is effective and for bonds one that ranges from 80-100%. The reason is that in an equity portfolio, currency risk contributes less to overall volatility than in a bond portfolio. Therefore you will need to hedge less to achieve the lowest possible risk. Interestingly, from a global perspective, we find, that the AUD is a special case whereby, if you hedge the AUD you actually increase total portfolio risk. Maybe it has to do with the AUD being used in carry trades a lot, but that is a wild guess.

Hedged share classes: You could buy the currency hedged shared classes of investment funds to invest globally without taking currency risks. Be careful to read exactly what and how the share class implements its currency hedging though.