As an avid sports fan, I cannot start this letter before saying congrats to the U.S. Women's National Soccer Team for winning their fourth World Cup, and thanking them for an amazing performance! After such an outstanding start of the year for sports fans, the only team sport remaining to enjoy over the next few weeks is baseball. Football season officially starts in early September, and some of you may already be strategizing about your fantasy football draft picks. We run a football survivor pool in our office, and one thing that I've noticed is that every year people tend to favor their home team even when the odds are against them. This is particularly, and sadly, true for Jets fans. This is classic home bias.
When it comes to sports, there is nothing materially wrong with favoring the team you know or like best. The worst that can happen is disappointment and the loss of your survivor pool entry fee. In the investment world, however, sticking to the familiar may pose real risks and turn into an expensive mistake.
According to data from the International Monetary Fund, the average U.S. investor has about 77% of his or her equity allocation invested in U.S. stocks. At the same time, U.S. stocks represent about half of the weight in the MSCI ACWI Index and the U.S. represents less than 25% of global GDP. Mutual Fund and ETF investors across the world are not the exception. According to the Morningstar Global Funds Database, as of 6/30/18, equity fund investors showed similar home biases. For example, almost 70% of the assets in equity funds available for sale in the U.S. were allocated to U.S. equities. In Japan and China, more than 90% was allocated to their respective home equities. This overallocation to U.S. companies is a prime example of home bias in investing. However, this bias is not limited to just U.S. investors - as the charts below show, investors in other countries also tend to be overallocated to stocks in their home country.
U.S. Stocks Have Global Exposure but Do Not Provide Global Diversification
Some U.S. investors may believe that being exposed to U.S. stocks, particularly large-cap companies that have operations and assets around the globe, already provides them with significant global exposure. Others may think that U.S. companies predominantly reflect the economic and political events and stability at home. In our opinion, both views tell some truth but neither offers a true global perspective.
A breakdown by geographic revenue exposure of the companies in the S&P 500 Index shows that nearly 40% of the total revenue over the past year came from abroad. The chart below shows that this figure has been fairly stable over the past 15 years. This should not be surprising, as many U.S. companies have significant global presence.
Naturally, international events are likely to have more of an effect on the U.S. companies with larger foreign exposure. For example, recent trade and policy uncertainties have translated into meaningfully lower revenue and earnings expectations for Q2 '19 for companies that derive more than 50% of their revenues from abroad, according to data from FactSet.
U.S. Companies with Higher Foreign Revenue Exposure are Facing Headwinds
Clearly, the financial results of U.S. companies are not driven just by U.S. events. Like it or not, investors in passive U.S. large/all-cap products have
significant unintended and unmanaged global exposure. While U.S. large/ all-cap active managers may have some flexibility to manage that exposure, it is not their mandate to do that, and investors would still be left to handle that risk on their own.
Because the large foreign revenue exposure of the S&P 500 Index is unintended and unmanaged, in our opinion it does not effectively eliminate home bias, nor can it effectively expose investors to the benefits of global growth.
A deeper dive into the data shows that the foreign revenues of the companies in the S&P 500 Index are geographically sourced in disproportion to the breakdown of global economic output. For example, only 6% of total revenue is derived from China (the second largest economy in the world) and 14% is coming from all emerging economies combined. At the same time, China represents over 16% of global GDP, and all emerging economies represent over 35%.
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This article first appeared on GuruFocus.