Reducing the home bias in equity investments
A broad global recovery and the introduction of LTCG tax improves the case for international diversification
For most of the 20th century, finance theory was built on the assumption that market participants are rational. It was one of the key assumptions of the efficient markets hypothesis (EMH), a theory that became the centre of attention for decades of empirical research in financial economics. However, in the 1990s researchers uncovered a series of anomalies and biases that challenged the validity and reliability of EMH, leading to the birth of behavioural finance as an independent area of research. Among the several biases discovered, one remains a puzzling global phenomenon: the home bias.
What is the home bias?
In a 1991 seminal paper titled ‘Investor diversification and international equity markets’, Kenneth French and James Poterba found that investors around the world held a large portion of their wealth in domestic assets.
In the US and Japan, the two largest stock markets at the time, more than 90% of equity portfolios comprised domestic stocks. Interestingly, it appeared to be the result of investor preferences rather than institutional constraints. This bias of the investor community, to prefer domestic assets over foreign assets, came to be known as the ‘home bias’. Several explanations have been put forward to explain the bias, but it remains a major puzzle in international economics.
How does it affect investors?
Anyone with a basic understanding of finance has heard the word ‘diversification’. Simply put, it means: don’t put all your eggs in one basket. Diversification reduces portfolio risk and can be achieved by spreading investments across asset classes, time, industries, companies and geographies. Since the home bias leads to geographically concentrated under-diversified portfolios, it exposes investors to large quantities of country-specific risk; which can emanate from political, social, economic or ecological events.
It is common knowledge that equity portfolios of many Indian investors comprise entirely of domestic stocks. In a recent paper in the Journal of Empirical Finance titled ‘Measures of equity home bias puzzle’, Anil Mishra uses several measures like the international capital asset pricing model, mean-variance, Bayes-Stein and Bayesian model to show that India exhibits a home bias of 0.9986, one of the highest in the world.
Of course, international investing comes with its own disadvantages and risks like currency risk, liquidity risk, custody risk and higher transaction costs. But, given the high home bias among Indian investors, a prudent portfolio allocation (around 10-15%) to international stocks would definitely improve the risk-return profile of their equity portfolios and protect them from suffering heavy losses due to India-specific shocks.
How to invest in foreign stocks
There are two ways in which Indian residents can invest in stocks abroad: invest directly in foreign stocks or invest in international equity mutual funds. Several broking houses provide an international trading facility, which investors can use to invest directly in foreign stocks. However, this option is recommended only if you are an experienced investor with the necessary skill and capacity for international active investing. Since India’s capital account is not fully convertible, direct investments in foreign stocks are subject to an annual cap of $250,000 under the Liberalised Remittance Scheme (LRS) of the Reserve Bank of India. For most retail investors, international funds provide a better alternative, especially since several funds have provided double-digit annualized returns in the past few years. Also, the LRS cap does not apply to investments in international funds.
Two factors increase the attractiveness of international investments in the current environment. First, a broad global economic recovery is underway. The World Economic Outlook Update released by the International Monetary Fund in January 2018 mentions that some 120 countries experienced a pickup in growth in 2017, making it the broadest synchronised global growth upsurge since 2010. Looking forward, global growth is expected to accelerate further in 2018 and 2019 as advanced economies start to grow faster than 2%. International diversification can help Indian investors take part in the global recovery.
Second, introduction of the long term capital gain (LTCG) tax in the Union Budget 2018-19 has created tax arbitrage between domestic and international equity investments under certain scenarios. While investment decisions should never be driven entirely by tax saving, it is a deal sweetener. Under the current taxation regime, international equity funds are treated as debt funds and the LTCG (for a holding period of more than 3 years) in debt funds is taxed at 20% with indexation. At the same time, LTCG in domestic equity funds will be taxed at 10% without indexation, starting 1 April 2018.
When indexation is applicable, the LTCG tax is calculated only on the real capital gain (nominal capital gain minus inflation). Thus, if the real capital gain in an international fund is less than 50% of the nominal capital gain in a domestic fund, then there is an opportunity to save tax by investing in international funds. However, if the real capital gain in international funds is higher, then this tax arbitrage is not available. It is also important to note that direct investments in foreign stocks do not enjoy similar tax advantages.
All in all, it may be a good time to take a small step towards international diversification.
Rohan Chinchwadkar is an assistant professor of finance at the Indian Institute of Management Tiruchirappalli.