Asset allocation: Why you could do with a little more home bias right now

Institutional investors and super funds have been slowly shifting their asset allocations away from Australian equities for several years. It’s now time to reconsider that drift, argues Pendal’s ALAN POLLEY

• Investors drifted away from Australian equities 
• It’s time to come back home
• Find out about Pendal’s multi-asset funds

A DECADES-LONG drift away from Australian equities should come to an end after institutions overshot investing in overseas markets, says Pendal multi-asset PM Alan Polley.

Traditionally, Australian investors had a distinct preference for investing at home. But over the past decade major institutions and superannuation funds shifted their attention overseas.

As a result, the “equity home bias” in the Australian investment industry fell below 50 per cent.

“There were good reasons for that shift, but we think it is now done,” says Polley, who co-manages Pendal’s multi-asset funds.

“We think Australian investors have drifted far enough – and we should start to see bias stabilise or even shift back to Australia.

“There are good reasons now to check your home bias and either keep it as it is and stop drifting — or even marginally go the other way and lift the home bias a little bit.”

Why we drifted

The drift away from Australia over the past decade was founded on valid reasons, Polley says.

“You can make the case that the home bias was too strong.

“Most investors had two-thirds of their equity portfolios here, but Australia’s market cap is less than 2 per cent of global equity markets.

“You were not getting diversification because there was risk concentration with one country and two main sectors – resources and banks.

“There was material security concentration as well. This all adds up to a higher level of risk.

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“The Australian market was also not very future forward. To get exposure to tech meant going to the US.

“Another reason for negativity was climate change. The Australian economy and equity market has a very high carbon intensity and that’s a bit of a headwind.”

Change in direction

Now, those arguments are losing their punch.

The ASX has been proactively wooing tech companies to list locally, leading to the emergence of a more material tech presence on the local market.

At the same time, private markets have successfully backed some fast-growing Australian tech companies.

“Five years or so ago, we didn’t really have any unicorns. Now, there are several Australian unicorns such as Canva and Immutable that give credence to the Australian market and business community.

“The number of tech stocks on the ASX300 has grown over the past decade from eight to 20 names, including companies such Xero and SiteMinder.”

Australia is also now better positioned to benefit from the climate transition, Polley says.

“Two years ago, lithium was basically nothing. Now it’s about a third of the value of thermal coal exports.

“So, there’s a shift in our energy export mix from dirty energy to clean energy via lithium.

“There’s also upside potential for critical-minerals mining, given our government’s ambition to become a renewable energy superpower, decarbonise the economy and increase clean energy exports such as green hydrogen.”

Why home bias works

Investing in Australian stocks delivers some genuine benefits over investing overseas, argues Polley.

For starters, investing in your home economy provides better linkages to local inflation because revenues and earnings are tied to domestic pricing.

“That gives you a hedge in your investment portfolio to the domestic inflation rate. That’s an attractive feature to have.”

Investing at home also comes with greater knowledge.

“You’re more likely know your own stocks, you’re more likely to use the products and services of your own stocks.

“Invest in what you know is a common investment adage. That’s another reason it’s less risky to have a home bias.”

Franking credits

Australia can also offer technical advantages over foreign stocks such as fewer friction costs such as tax and fees, argues Polley.

Australia is one of the few countries in the world to offer a franking credit system that ensures investors are only taxed once on dividends.

And we are the only country that refunds unused franking credits, in cash by the ATO! Australia is very generous when it comes to shareholders.

Because franking credits are not useful to all investors, they are not fully priced by the market, says Polley.

This means they offer a material after-tax return uplift for local investors, especially when compounded over time.

“It’s a nice additional income pickup that you’re not going to get from investing overseas, and especially for retirees.”

Cost differences also make investing at home worthwhile.

Investing overseas means more complexity, dealing with many more securities, tax complications and managing different markets and different currencies.

“There’s more trading, there’s more accounts that need to be opened. These are all additional look-through costs that are associated with investing overseas that are often hidden in the net return.

“It is not as clean as investing in Aussie shares.”

Potential for better returns

Polley’s capital market assumptions for long-term market returns across various asset classes suggest Australian equities could outperform international equities over the next decade.

That would be a reversal of the last decade where Australian equities went into a post-resource-boom coma, while international equities were supported by lower interest rates.

“Long-term forward return expectations are really just a summation of dividend yield and growth rate.

“The dividend yield for the Australian market is around 4.3 per cent — even before franking credits — while international equities are yielding about 2 per cent.

“So just on the dividend alone, there is a 2.3 per cent additional return.

“That’s a lot of return for growth to make up for — and we don’t think international equities will have that much more growth than us, especially given high starting valuations and what’s likely to be a higher interest rate world.”

“The Australian dollar is also on the cheaper side vs the USD, and the Fed is more ahead on its interest rate cycle. That could see the AUD appreciating over the medium term.”

“This potential additional return more than makes up for the additional volatility of Australian equities due the higher sector and stock concentrations,” Polley argues.

Fees may be lower

Another underappreciated feature of the Australian market is that funds management fees for Australian equities can be lower than international equities.

“The Australian funds management industry is very competitive, and it can be cheaper and less resource intensive to manage an Australian shares portfolio.”

Australian equity managers may also benefit from a less efficiently priced domestic market.

“There’s a large portion of retail investors in the Australian market, so they are more likely to be on the losing side of trades — thus professional managers can find mis-priced stocks.”

Also, large global fund managers tend to view Australia as a bit of a rounding error, often buying and holding a couple of big miners and retail banks and forgetting the rest. This results in less price discovery.

It’s not widely understood that our standard market index, the ASX 300, is a broad-cap index that includes large, mid and small-cap stocks.

Global counterparts like the S&P500, FTSE100, DAX and CAC are all large cap indexes.

“We all know that small caps tend to be less efficiently researched, and thus less efficiently priced.

“So that’s a place where excess returns can be found.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal key account manager here