When I started out in 2001 we managed money for mainly UK charities and some private clients. A typical portfolio had about 60% in direct UK equities, 20% overseas equities (mostly in funds), and 20% in cash and direct bonds (meaning gilts – no overseas, no investment grade, high yield would get you laughed out of the room). If you were a bit racy we might have closed our eyes and added some property.
Things change. Using data from New Financial (which is a capital markets think tank), a fund we met last week showed the UK has relatively large pension fund assets at just over £3 trillion. The UK is now famously just 4% of the MSCI World Index, and our overall pension fund assets invested in UK equities are also at 4%, vs 26% in global equities.
This makes the UK a big outlier in comparison to other countries, who have retained a large home bias to their own equity markets. Australia for example has a broadly similar £2.7 trillion pension assets. Australia is 2% of the MSCI World but invests 24% of pension assets in its home market – more than half its 46% equity total.
Much like in sports, no one is completely sure why home bias exists, especially when the world has become much more global, even since 2001.
I read an academic paper about it to see if they knew (“The Equity Home Bias Puzzle: A Survey”, by Ian Cooper, Piet Sercu and Rosanne Vanpee).
They surveyed the existing literature on the issue and tried to work out why investors give up potential return and diversification benefits in exchange for investing in things close to home that are more recognisable. As well as home bias, they found that even where investors diversify overseas, they tend to do it in places that are close by.
They essentially come up with a series of small differences, such as the additional cost of overseas trading, various theories that home bias acts as a hedge against future consumption and labour income, the information asymmetry argument (a domestic Brazilian investor probably knows more about Brazil than I do), and something about investors under-estimating overseas equity returns. All are shown to be either too small to explain home bias, or not even quantifiably true in the first place (the ones about it being a hedge).
The most commonly accepted reason seems to be behavioural bias. We tend to relate to things that are familiar. Something like HSBC has little to do with the UK apart from its listing, and there is no real investment related reason to be more comfortable buying it over (large Chinese bank) ICBC, or (large Indian bank) HDFC.
But we walk past HSBC branches all the time, we might have a bank account or other product with them, we see their adverts – the corporate logo is (perhaps surprisingly?) recognisable. I couldn’t tell you what the ICBC logo looks like and if Hawksmoor sent out client valuations full of these unfamiliar names, I imagine we would get a lot of questions.
Also behaviourally, we tend to think of further away countries as more “risky” – usually meaning more volatile. But Emily wrote earlier this year that emerging market equities have become less rather than more volatile than developed market equities. This is largely because many emerging market countries are less correlated with each other and provide more genuine diversification then a portfolio made up of the UK, Europe and US who do tend to follow each other.
Does any of this matter? Yes – the Australian equity market is currently trading on nearly 19x next year’s earnings and is up nearly 14% YTD. The UK market trades just under 12x next year’s earnings and is up about 11% YTD.
The UK IPO market has stagnated in recent years. We had 126 new listings in 2021, 74 in 2022, 23 in 2023 and just 10 so far in the first three quarters of 2024. This is in part a function of the low valuation, which makes it less attractive to potential sellers.
But it makes the market less dynamic, the number of listed companies has been shrinking. M&A activity has been high – private equity appears to believe the UK offers attractive value, even if public equity investors disagree.
News came in last week that the UK equity market saw its first monthly inflows in nearly 4 years – £317m in November. £25bn has been taken out since 2021.
There are different ways we could approach this, but as a slightly random example, if the UK mirrored Australia and allocated 52% of its equity to its home market that would be 15.6% of pension assets, which is just under £500bn, which is over 10% of the £4.2 trillion UK market. This would undoubtedly have a huge impact.
We could argue about the UK equity market being bigger than Australia’s, or the overall Australian pension fund equity allocation being bigger than in the UK. There are many ways we could compare and contrast, and come up with a different number, but the point is any kind of alignment of UK equity allocations in our pension funds with their overseas equivalents, would have a sizeable impact on the UK market.
I haven’t cherry-picked Australia either, I just think it is a good example with similar assets and no real reason to invest in its home market. Japan has £3.3 trillion pension assets and invests nearly half its equity allocation in Japan, South Korea invests about a third of its equity allocation in South Korea, Switzerland also about a third.
Should the government get involved? You might say we shouldn’t interfere in this. Pension funds should be free to do whatever they want. The government is probably useless at asset allocation anyway. I get this.
But pension funds do not pay capital gains tax. The pound amount this is worth to them depends on your assumptions. A very back of an envelope starting point is £3 trillion of assets, let’s put a 7% annual return on that, charged at the new CGT rate of 24%, I make that to be about £50bn a year in tax breaks to pension funds. I absolutely do think the government can look at this, perhaps by looking at ways to incentivise rather than force UK equity allocations higher.
I was surprised to see them reduce Business Property Relief available to qualifying AIM stocks in the recent budget. Most of the debate here was framed around the end investor and is it “fair” for individuals to reduce their inheritance tax bill in this way. But to me at least the real meat of the argument is on the other side – the effect these changes are likely to have on the ability of smaller UK growth companies to attract capital.
The multiplier effect of small companies establishing themselves, employing people, generating growth and paying tax themselves is page one GCSE economics. I thought it was an unusual message for the incoming government to send, given the way they have talked up the importance of the UK economic growth at other times.
The UK has historically been good at this – we are globally competitive in financial services. But I’m not sure how well we have been looking after it recently. Similar sized, developed market countries seem to have no issue in using home bias to their own advantage, even though there appears to be little academic basis for it.
Robert Fullerton – Senior Research Analyst
FPC24234
All charts and data sourced from FactSet
Hawksmoor Investment Management Limited is authorised and regulated by the Financial Conduct Authority (www.fca.org.uk) with its registered office at 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. This document does not constitute an offer or invitation to any person in respect of the securities or funds described, nor should its content be interpreted as investment or tax advice for which you should consult your independent financial adviser and or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. The editorial content is the personal opinion of Robert Fullerton, Senior Research Analyst. Other opinions expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represent the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. Currency exchange rates may affect the value of investments.
