Download New Evidence on the Home Bias in European Investment

DSF POLICY BRIEFS
No. 34/ September 2014
New Evidence on the Home Bias in European Investment
Dirk Schoenmaker, Duisenberg school of finance
Chiel Soeter, Duisenberg school of finance
Abstract
The introduction of the euro led to a decrease of the home bias in the euro area countries, while the
regional bias (investment in European equities and bonds) increased. These effects are well
documented in the literature. What is the impact of the financial crisis on the home bias? This policy
brief provides new evidence showing that the equity home bias further decreased, while the bond
home bias increased. The regional bias remained strong for the euro area countries.
1. Measuring the home bias
A home bias exists when investors underweight foreign assets in their portfolio while this might not be
optimal from a diversification point of view. There is robust evidence across a large range of countries
for the existence of such a home bias (Chan et al., 2005). This policy brief analyses to what extent
(institutional) investors in Europe diversify their investments geographically. By comparing the levels of
the home bias between 1997 and 2012, it is possible to analyse whether the home bias has declined
over time. We distinguish two periods: the start of Economic and Monetary Union (EMU) (1997-2004)
and the financial crisis (2004-2012). The first period may lead to a decreasing home bias, as exchange
rate risk is eliminated for the euro area countries. The second period may lead to an increasing home
bias, as financial market turmoil may induce investors to withdraw their investments from abroad to the
home market which they know best (the retrenchment effect).
To derive the home bias, the international Capital Asset Pricing Model (CAPM) is used. The optimal
portfolio with no bias can be calculated under strict assumptions (Elton et al., 2007). In the international
setting, these assumptions include fully integrated capital markets, which implies that investors can buy
and sell securities in foreign markets without any restrictions or extra transaction costs. Equilibrium in
the international setting is achieved when all investors hold the world market portfolio in which each
country portfolio is weighted by its market capitalisation.
The equity home bias, labelled EHBi, is measured as one minus the foreign asset acceptance ratio
which measures the extent to which the share of foreign assets in the portfolio of country i diverges
from the relative share of foreign assets in the total world market portfolio (Ahearne et al., 2004). The
home bias is higher, the more the foreign asset acceptance ratio is below unity. The equity home bias
is given by:
(1)
in which Foreign Equityi = share of country i’s holdings of foreign equity in country i’s total equity
portfolio (1 – share of domestic equity); Foreign Equity to Total Marketi = the share of foreign equity in
the world portfolio available to country i (1 – share of country i in the total market capitalisation). The
country portfolio is calculated as the domestic market capitalisation plus foreign equity holdings minus
foreign owners of domestic equity.
Equation 1 measures to what extent domestic equity is overweighed compared with foreign equity in
the investment portfolio. EHB will be equal to 0 if investors show no preference for equity issued
domestically. If domestic investors have a preference for domestic equity, the ratio will be between 0
and 1. The home bias formula can be illustrated as follows. Country i investors allocate 15 percent of
their portfolio to foreign equity, while the total world market portfolio comprises 75 percent of foreign
equity and 25 percent of domestic equity. Country i investors thus exploit international diversification to
only one-fifth (15/75) and thus have a home bias of 0.8. EHBi is 1.0 if domestic investors invest 100
percent of their equity portfolio domestically. In a similar vein, the preference of investors for domestic
debt securities can be measured. This home bias measure for bonds is BHBi.
Next, the regional bias can be measured. The question is whether European investors show a
preference for European securities in their foreign securities portfolio in comparison with US securities.
Within the part of the investment portfolio that is invested in foreign equity and bonds, EU investors
should, according to the international CAPM, show no preference for either European or US equities
and bonds.
Similar to the analysis of the domestic home bias, it can be tested whether European investors have a
bias towards European equities and bonds. The regional bias for European investors is measured as
one minus the US asset acceptance ratio. This ratio measures the extent to which the share of US
assets in the foreign equity portfolio of country i diverges from the relative share of US assets in the
total foreign market portfolio. The regional bias for equities is given by:
(2)
in which US Equityi = share of country i’s holdings of US equity in country i’s total foreign equity
portfolio (1 – share of EU equity in foreign portfolio); US Equity to Foreign Market Portfolioi = share of
US equity in the foreign-equity portfolio which is available for country i. The available foreign portfolio
for country i is total domestic market capitalisation of EU and US minus domestic market capitalisation
of country i.
The foreign market portfolio differs per country. For example, as the UK comprises a large part of total
EU equity, the foreign equity portfolio for the UK is smaller than that of other countries. The same
applies to the foreign bond portfolio. It is expected that the regional bond bias (RBB) is higher than the
regional equity bias (REB) for the countries in the euro area, because there is no exchange rate risk
involved, and international diversification of bonds primarily focuses on credit risk diversification.
2. Evidence on the home bias
Some earlier empirical studies measure the development of the home bias in the EU-15 after the
introduction of the euro in 1999 (De Santis and Gérard, 2009; Schoenmaker and Bosch, 2008). These
studies show a large decrease in the home bias and an increase in the regional bias for the euro area
countries. Updating these earlier studies, we extract data concerning foreign equity and bond holdings
from a country-level dataset of the IMF, the Coordinated Portfolio Investment Survey (CPIS), to
examine the home bias for the original EU-15. Luxembourg and Ireland are excluded as they attract
large amounts of foreign investment due to favourable tax policies, while the largest new Member State
Poland is added to the dataset. This results in the EU-14.
The international diversification strategy of institutional investors is graphically illustrated in Figures 1
and 2. Data for 1997, 2004 and 2012 are compared for four regions: the US, the EU-14, the ten euro
countries within the EU-14, and the four non-euro countries within the EU-14. Figures 1 and 2 illustrate
that the decline in the home bias is larger for the EU than for the US. Within the EU-14 countries, the
ten euro countries show a larger decline in the home bias than the four non-euro countries.
Starting with the EHB, all countries experienced a sharp decline from 1997 to 2004 (see Table 1 in the
Annex for a country breakdown). The Netherlands has the lowest home bias (0.44 in 2004); it also had
the largest decline from 1997 to 2004. The low home bias in the Netherlands can be explained by a
large proportion of institutional investors, in particular pension funds, that tend to invest in a
professional way applying international diversification. Rubbaniy et al. (2013) find a large decrease in
the home bias of pension funds’ investments in equities and bonds after the introduction of the euro.
The southern European countries have a bias around 0.90 and the new Member State, Poland, also
has a very high home bias of 0.99. The equity home bias in the UK and the US decreased slightly from
1997 to 2004 but was still relatively high (0.80 and 0.82, respectively).
The weighted average bias for the EU-14 declined by 0.08 from 1997 to 2004 (see Figure 1). It is
interesting that the EU bias has decreased after the introduction of the euro, without a significant
change of the US bias over this period. While the weighted-average bias for the countries in the euro
area was higher in 1997 than the bias of the non-euro countries, the bias for the countries in the euro
area decreased by 0.10 from 1997 to 2004 compared with 0.05 for the non-euro countries.
There is a small decrease in the EHB for all countries from 2004 to 2012. So there is no evidence of a
clawing back of equity investments to the home country after the financial crisis. Employing a novel
methodology to disentangle the active and passive component of portfolio holdings, Wynter (2012)
finds that the trades of investors (the active component) increased the home bias, but the changes due
to returns and exchange rates (the passive component) subsumed the active changes and reduced the
home bias during the crisis of 2008.
Figure 2 illustrates that the BHB declined by 0.17 from 1997 to 2004 for the euro area countries in the
sample. This reduction is in general larger than that of the EHB. This can be attributed to the
introduction of the euro. In 2004, the BHB is the lowest for Belgium (0.58), followed by Finland and the
Netherlands (see Table 1 in the Annex for a country breakdown). On the other side of the spectrum are
Denmark, Sweden, Greece, Italy and Poland that still exhibit a large BHB relative to the other EU
Member States. The latter sample includes some non-euro area countries, which experienced an
increase of 0.04 in 2004.
The US has an exceptionally high BHB at 0.96. It can be concluded that US investors are very
domestically focused within their long-term debt portfolios, and allocate only a small percentage of their
bond portfolio to EU bonds. This is partly in line with theory. As the US economy is very large, there is
more scope for US investors to diversify credit risk domestically without incurring exchange-rate risk.
But there is an increase in the BHB in the 2004-2012 period. The financial crisis and subsequent euro
sovereign debt crisis has led to an increase in the home bias (except for Germany and Denmark). So,
foreign investors fled the crisis stricken countries (Greece, Ireland, Portugal, Spain and Italy) and
invested at home. Domestic investors in the latter (in particular in Portugal, Spain and Italy) had to pick
up these bonds, also increasing the home bias in the distressed countries.
Figure 1 Equity home bias per region, 1997 vs. 2012
Figure 2 Bond home bias per region, 1997 vs. 2012
3. Evidence on the regional bias
As illustrated above, all countries in the sample exhibit a home bias towards domestic equities and
bonds. Within the portfolio of foreign securities of the 15 countries in the sample, a distinction can be
made between investments in European and US securities. If the home bias puzzle is mainly a
geographical phenomenon, this implies that within their foreign portfolio European investors give too
much importance to European securities.
Figures 3 and 4 show the output concerning the regional bias for equities and bonds. Investors in all
European countries in the sample overweigh European relative to US equities. This means that the
home bias also persists on a regional level. The weighted average REB for the EU-14 increased by
0.03 from 1997 to 2004 (see Figure 3). The split between countries inside and outside the euro area
identifies an interesting pattern. The REB increased by 0.10 for the euro countries, while the bias
declined by 0.08 for the non-euro countries.
The Netherlands has the lowest REB of the EU-14 countries (0.11 in 2004), followed by Sweden and
Greece (see Table 2 in the Annex for a country breakdown). By contrast, Belgium, France, Spain,
Austria and Italy show a high preference for European equities in their foreign- investment portfolios. It
is remarkable that the bias of Portugal, Spain, and France increased strongly from 1997 to 2004.
Investors in these countries evidently moved to a euro area investment strategy and thereby reduced
their foreign (US) equity holdings. The 2004-2012 period indicates a decrease of the regional bias.
Nevertheless, the REB for the euro countries in 2012 is substantially higher than in 1997.
Figure 4 shows the RBB of European investors. The weighted average for the EU-14 countries
increased by 0.08 from 1997 to 2004. The increase in the RBB was driven by the euro area countries.
The RBB increased by 0.11 for the countries in the euro area and declined by 0.02 for those outside.
The absolute value of the bias in 2004 was almost twice as large for the euro countries (0.80) than for
the non-euro EU countries (0.42). Denmark, Sweden and the UK (which are all non-euro countries)
have a low RBB. It can be concluded that for the euro area countries the decline in the BHB is caused
by a shift from domestic towards EU-14 bonds, and not to US bonds. These countries diversify the
credit risk of the bond portfolio to a significant extent, but within the EU. The interest rate risk is hedged
by investing primarily in EU bonds, which have interest rates that are almost identical (euro area) or
linked (non-euro area) to domestic rates. Moreover, exchange-rate risk is largely eliminated. The
subsequent 2004-2012 period shows a very small increase in the RBB.
Figure 3 Regional equity bias per region, 1997 vs. 2012
Figure 4 Regional bond bias per region, 1997 vs. 2012
We can now combine our findings. While the equity and bond home bias in the euro area have
declined faster than in the non-euro countries (Figures 1 and 2), the reverse is true for the regional bias
(Figures 3 and 4). In fact, the regional bias has increased for both equity and bonds in the euro area,
but has decreased on average for the four non-euro countries. These results are consistent with the
theory of economic integration. Since the introduction of the euro in 1999, investors in the euro
countries have allocated a larger part of their portfolio to foreign assets than have non-euro countries
and the US. At the same time, the regional bias of the euro area has increased, as investors in euro
countries have invested their foreign assets mainly in other euro area countries. Investors based in the
euro area have thus shifted from a country-based investing strategy towards a sector-based strategy.
So there is a ‘euro effect’ as the euro has caused a decrease of the home bias but an increase of the
regional bias. The regional bias decreased for the non-euro countries, which means that they partly
shifted their foreign assets towards US assets compared with EU assets.
4. Conclusions
Finance theory suggests that investors should aim for international diversification of their investment
portfolio to maximise returns given a certain risk profile (Elton et al., 2007). Nevertheless, there is a
strong home bias in equity and bond portfolios. This policy brief confirms earlier research that the
introduction of the euro has led to a strong decline of the home bias in the euro area, due to the
elimination of exchange rate risk.
New evidence in this policy brief indicates that the equity home bias decreased further over the crisis
period, albeit with a small amount. Therefore the financial crisis may have supported investors to
withdraw their investments from abroad to the home country, on the long run it did not take away the
decreasing trend in the equity home bias. Wynter (2012) also finds a small decrease during the crisis
of 2008. The passive changes related to stock returns and exchange rates (reducing the home bias)
were bigger than the active trades of investors (increasing the home bias), resulting in a net decrease.
For the long term outlook, Levy and Levy (2014) argue that the equity home bias is here to stay. As
correlations have been steadily increasing from 0.4 in the 90’s to about 0.9 today, benefits from foreign
investments become smaller.
A distinction can be made between two groups. The first group of small open economies (comprising
Austria, Denmark, Finland and the Netherlands) has a very low equity home bias of about 0.50 to 0.65,
while the second group has a higher home bias (in particular, some of the southern European
countries have a bias ranging from 0.80 to 0.98).
By contrast, the bond home bias increased over the crisis period. That can be explained by the euro
sovereign debt crisis. Investors increasingly avoided the crisis-stricken countries. At the same time,
domestic investors in the crisis-stricken countries picked up these bonds, as it is politically more
difficult for a country to default on its bonds when the investor base is domestic.
References
Ahearne, A. B., W. Griever, and F. Warnock (2004), Information Costs and the Home Bias, Journal of
International Economics, 62, 313–336.
Chan, K., M. V. Covrig, and L. K. Ng (2005), What Determines the Domestic Bias and Foreign Bias?
Evidence from Mutual Fund Equity Allocations Worldwide, Journal of Finance, 60, 1495–1534.
De Santis, R. A. and B. Gérard (2009), International portfolio reallocation: Diversification benefits and
European monetary union, European Economic Review, 53, 1010-1027.
Elton, E. J., M. J. Gruber, S. J. Brown, and W. M. Goetzmann (2007), Modern Portfolio Theory and
Investment Analysis, 7th edition, John Wiley & Sons, New York.
Levy, H. and M. Levy (2014), The home bias is here to stay, Journal of Banking & Finance, 47, 29-40.
Rubbaniy, G, I. van Lelyveld and W. Verschoor (2013), Home bias and Dutch pension funds’
investment behavior, European Journal of Finance, forthcoming.
Schoenmaker, D. and T. Bosch (2008), Is the Home Bias in Equities and Bonds Declining in Europe?,
Investment Management and Financial Innovations, 5, 90-102.
Wynter (2012), Why Did the Equity Home Bias Fall During the Financial Panic of 2008?, Mimeo, Ohio
State University.
ANNEX
Table 1 Equity and bond home bias, 1997–2012
Equity home bias
Bond home bias
1997
2004
2012
Δ 97–04
Δ 04–12
1997
2004
2012
Δ 97–04
Δ 04–12
Austria
0.81
0.67
0.65
-0.14
-0.02
0.81
0.66
0.75
-0.14
0.08
Belgium
0.86
0.72
0.74
-0.14
0.02
0.82
0.58
0.67
-0.24
0.09
Denmark
0.83
0.73
0.63
-0.10
-0.11
0.91
0.87
0.87
-0.04
0.00
Finland
0.96
0.75
0.61
-0.21
-0.14
0.93
0.60
0.61
-0.33
0.01
France
0.90
0.79
0.79
-0.11
0.01
0.87
0.69
0.76
-0.18
0.07
Germany
1.00
0.77
0.80
-0.23
0.03
1.00
0.80
0.73
-0.20
-0.07
Greece
1.00
0.97
0.98
-0.03
0.01
1.00
0.83
0.86
-0.17
0.03
Italy
0.89
0.84
0.78
-0.04
-0.07
0.93
0.84
0.91
-0.10
0.07
Netherlands
0.77
0.44
0.49
-0.33
0.05
0.75
0.61
0.70
-0.14
0.09
Poland
1.00
0.99
0.99
-0.01
0.00
n/a
0.99
1.00
n/a
0.00
Portugal
0.94
0.86
0.80
-0.09
-0.06
0.87
0.67
0.84
-0.20
0.17
Spain
0.95
0.93
0.94
-0.02
0.02
0.95
0.68
0.93
-0.26
0.24
Sweden
0.87
0.73
0.70
-0.14
-0.03
n/a
0.83
0.88
n/a
0.05
UK
0.84
0.80
0.76
-0.04
-0.04
0.73
0.78
0.82
0.05
0.03
US
0.84
0.82
0.75
-0.02
-0.06
0.95
0.96
0.96
0.01
0.00
EU-14
0.85
0.77
0.75
-0.08
-0.03
0.84
0.73
0.82
-0.10
0.08
Euro area
0.86
0.76
0.74
-0.10
-0.02
0.87
0.70
0.81
-0.17
0.11
Non-euro area
0.84
0.79
0.75
-0.06
-0.04
0.76
0.80
0.83
0.04
0.03
Note: EU-14, euro, and non-euro area are calculated as a weighted average; n/a means not available.
Source: Authors calculations based on Coordinated Portfolio Investment Survey, IMF.
Table 2 Regional equity and bond bias of European investors, 1997–2012
Regional bias towards EU-14 equities
Regional bias towards EU-14 bonds
1997
2004
2012
Δ 97–04
Δ 04–12
1997
2004
2012
Δ 97–04
Δ 04–12
Austria
0.55
0.57
0.72
0.02
0.16
0.63
0.85
0.83
0.21
-0.02
Belgium
0.70
0.76
0.73
0.06
-0.03
0.65
0.90
0.88
0.25
-0.02
Denmark
0.59
0.40
0.14
-0.19
-0.25
0.71
0.62
0.68
-0.09
0.06
Finland
0.70
0.73
0.54
0.03
-0.19
0.72
0.89
0.91
0.17
0.02
France
0.49
0.74
0.73
0.24
-0.01
0.71
0.78
0.82
0.08
0.04
Germany
n/a
0.62
0.56
n/a
-0.06
n/a
0.86
0.84
-0.14
-0.02
Greece
n/a
0.24
0.25
n/a
0.01
n/a
0.80
0.94
-0.20
0.14
Italy
0.54
0.52
0.71
-0.02
0.19
0.56
0.73
0.78
0.17
0.06
Netherlands
0.27
0.11
0.12
-0.15
0.00
0.79
0.73
0.74
-0.06
0.02
n/a
n/a
n/a
n/a
n/a
n/a
n/a
n/a
n/a
n/a
Portugal
0.34
0.80
0.63
0.46
-0.17
0.53
0.83
0.87
0.30
0.04
Spain
0.35
0.73
0.73
0.38
0.00
0.83
0.81
0.87
-0.02
0.06
Sweden
0.28
0.24
0.31
-0.04
0.07
0.43
0.54
0.62
0.11
0.08
UK
0.47
0.37
0.15
-0.10
-0.22
0.42
0.33
0.38
-0.09
0.05
EU-14
0.44
0.47
0.38
0.03
-0.09
0.66
0.74
0.76
0.08
0.01
Euro area
0.43
0.53
0.49
0.10
-0.04
0.69
0.80
0.82
0.11
0.02
Non-euro
area
0.46
0.38
0.24
-0.08
-0.14
0.44
0.42
0.46
-0.02
0.04
Poland
Notes: EU-14, euro, and non-euro area are calculated as a weighted average; n/a means not available.
Source: Authors calculations based on Coordinated Portfolio Investment Survey, IMF.