Why International Diversification Benefits Canadian Investors

Our annual ETF Investor Pulse survey shows that Canadian investors invest three-quarters of their portfolios domestically, exhibiting a large "home bias" - the tendency to prefer domestic over global securities. Although this bias is not unique to Canada, the implications are greater for Canadian investors because the domestic equity market is smaller, narrower, and contains large sector tilts. In our view, geographic diversification is as important as asset class diversification for Canadian investors. To make the case, we provide three examples that demonstrate how international equity exposure can enhance portfolio performance.

Participating in the global growth story

It's easier for Canadian investors to achieve a portfolio with substantial home bias because unlike the U.S., Japan, and Europe, Canada's economy and financial markets are a relatively small share of the overall pie. Canada represents just 3% of the world equity markets based on MSCI data and an even smaller share of global GDP according to the IMF (it's just 1.4% in case you were wondering). It's a big world out there. Limiting a portfolio to Canadian stocks ignores over 95% of the investment universe.

Some argue that because the Canadian stock market includes multinational companies, it reduces the need to invest in foreign securities. Although true, the exposure is insufficient. For one, there is simply no substitute for gaining direct exposure to industry leading firms, many of which are found internationally (for example, European luxury goods, U.S. technology). Additionally, earnings outside of Canada tend to be more sensitive than Canadian earnings to global economic activity (see the chart below). A Canadian-centric investor may feel like they're missing out during economic expansions. Moreover, global stocks have delivered a slightly better return on equity this century than Canadian listed companies, despite wide variability across geographies and time.

The chart above paints an overwhelmingly supportive picture for investing in global stocks, leading one to rightly ask: why even bother allocating to Canada at all? Although it's tempting to favour previous winners, we acknowledge that market leadership is volatile and putting all your eggs in one basket is seldom advised. Abandoning the Canadian equity market would have resulted in missing out on some outperformance in 2010 and 2016 (see the chart below).

Improving sector and security diversification

Relative to global equity markets, Canada is heavily concentrated in energy, financials, and materials companies, which collectively account for almost two-thirds of the index. Canada is also significantly underweight technology and healthcare sectors, two key driving forces behind global earnings growth. A Canadian-centric investor would be skewed toward cyclical industries (with minimal exposure to secular growth), which could be a recipe for heightened volatility throughout the cycle. Geographical diversification can help alleviate the Canadian equity market's industry sector mismatch.

Concentration comes in another form: When too few companies make up a large share of the index, investors could be placing large bets on single companies. In Canada, the ten largest holdings within the S&P/TSX Composite Index account for 37% of the total index, a standout figure when compared against major global markets. Reducing stock-specific risk is another important reason to invest globally.

Enhancing your risk/return tradeoff

A portfolio focused entirely on a single country tends to be inefficient. In order words, an investor may be taking on more risk than needed to achieve a given level of return. Using the most recent full cycle dating back to 2007 as a guide, a hypothetical portfolio of 60% global stocks and 40% Canadian bonds slightly edged the S&P/TSX Composite Index's cumulative return, but with almost half the amount of volatility (see the chart below). The global portfolio climbed more steadily with comparatively shallow drawdowns, which could have helped reduce the likelihood of investors withdrawing money at an inopportune time.

It is important to acknowledge that the picture didn't always look this way. If we use the full range of data available starting from 1995, cumulative returns favored Canadian stocks. Nevertheless, adding international exposure still reduced volatility, improving the risk-return tradeoff (see the chart below). One may argue performance leadership of Canadian versus global equities runs in cycles, which is a valid point. But given the current state of affairs, we don't see the period of the commodity supercycle (mid-1990s until the 2008 financial crisis) repeating itself.

Conclusion

Two important questions remain, what percentage should I allocate to international equities and what degree of home bias makes sense?

Correcting a home bias doesn't necessarily require reducing Canadian exposure to a weight that mirrors the world index (i.e. 3%). A theoretical efficiency frontier using data since 2007 suggests the new starting point for the international equity allocation is two-thirds of the equity portfolio (see the chart below). Over the period that includes the commodity supercycle dating back to 1995, the efficient frontier would have arrived at a very different conclusion: potentially much higher allocations to Canadian stocks at higher levels of volatility. But as we've already noted, we think this secular story is unlikely to repeat.

There are other real world factors that could drive down an ideal international allocation, such as taxation (dividend investors may prefer a higher allocation to domestic stocks due to more favorable tax treatment). Even so, a degree of international exposure tends to be beneficial as a mechanism to participate in a global opportunity set, diversify undesired risks, and improve overall portfolio efficiency.

This post originally appeared on the BlackRock Blog.