Where we come from, live or work often influences the way we invest. Be aware of such familiarity biases, learn to recognize their risks, and opt for diversified portfolios that seize opportunities wherever they may be.

By Xavier Vegas

Home Sweet Home
 

The place we call home has a big influence on us—from the products we buy and the foods we eat to the sports teams we support, we tend to gravitate toward what’s close and familiar. This is also the case with investments, particularly in fixed income.

We all like to invest in what we think we know—it gives us the feeling of confidence that despite market volatility, we will end up doing well. Unfortunately, several instances over time point to cognitive bias playing tricks on us.

Statistics show that U.S. investors have nearly 75% of their investments in U.S.-based assets, despite the fact that the United States accounts for just over 35% of the world’s capital markets. (Source: J.P. Morgan Asset Management Guide to the Markets, 2019.)

In the same vein, investors in emerging markets fixed income often prefer to invest in corporates and sovereign credits of the countries they reside in, based on the familiarity and expectation that they understand the credit risks better and will be able to recoup interest plus principal regardless of the volatility.

This home-country bias creates at least three potential risks to clients’ portfolios that could be easily avoided when recognized:

1. Concentration risk

As the old proverb says, “Don’t put all your eggs in one basket.” While this can apply to almost anything in life, it is especially important in regard to one’s portfolio construction strategy. Having an overexposure to what’s close and familiar could mean having a sizable exposure to highly correlated assets. In other words, large components of your portfolio will all move in one direction together, which can prove particularly damaging if that direction is a negative one, and if there aren’t enough safe or uncorrelated assets to provide a cushion to any losses.

Concentration also presents itself in the risk of having savings (balance sheet) subject to the same macro risk environment of the operating businesses (wealth creation). When negative economic environments affect a country, hard-earned investment savings become subject to volatility at the same time operating businesses encounter difficulties, often times when savings are most needed. Concentration risk has impactful ramifications because it limits the ability to take advantage of new business opportunities or to sustain a period of challenging market environment.

2. Familiarity risk

Making a decision based on familiarity can manifest itself in various ways. For example, employees in technology firms tend to own portfolios heavily weighted in technology stocks. There is nothing inherently misguided about investing in what is familiar. However, it is important to understand if that decision—to own investments in the same sector in which one works—is an intentional decision, and the ways that decision could impact your future.

Geographic familiarity bias is also very common. If we are very familiar with a country or region, we tend to invest more heavily there. This is evident when we look at portfolios coupled with residency. The fundamental principle for this bias is that a local business you know well feels more creditworthy than a foreign, unknown business. However, recognizing the name of a company or its location doesn’t make it a safer investment—it just feels that way.

It is important to separate what feels risky to what is risky. A good approach is to dig into the numbers. Creditworthiness stems from two factors: the ability to pay (cash flows, size of debt load, interest servicing costs, etc.), and the willingness to do so.

3. Drawdown risk

Albeit in varying degrees, emerging markets are likely to be impacted by the volatility associated with cracks in the rule of law. This is important to take into consideration when portfolios are heavily invested in emerging markets that might feel physically or emotionally close to the investor.

In markets prone to volatility—such as emerging markets—large individual losses on fixed income prices tend to occur from time to time, particularly during a recession or periods of social and political unrest. And recoveries tend to be very slow, especially when a country lacks fair debt resolution frameworks such as bankruptcy, where creditors can enforce their rights and get recourse to the assets.

In addition to risks of default and/or restructuring, we have innumerable “repricing” situations where the concentration in exposure has created painful drawdowns (market-to-market losses). When these drawdown risks materialize, the overexposed investors tend to retrench and stay away from those markets, which in turn can generate missed opportunities, and in the worst cases can cause them to sell when they should be investing.



Finding opportunities for capital generation and preservation, while managing volatility
 

Despite the risks, emerging markets fixed income has offered attractive returns on risk-adjusted terms (volatility) through its history.¹ The question is how to achieve a favorable outcome in the space.

Emerging markets can offer faster rates of economic growth than the developed world, since factors such as demographics, a growing middle class and the development of infrastructure may help generate wealth and dynamic companies with significant growth potential. To take advantage of these opportunities while mitigating volatility, we believe diversification across countries paired with a solid credit selection process provides favorable outcomes.

Diversification is the name of the game. To visually illustrate the importance of having diversified sources of return, see below:

CEMBI and Sub-Indices Sharpe Ratio* vs. Max Drawdown**

*Sharpe Ratio: (Annual Return – Risk-Free Rate)/Annual Volatility; Risk-Free Rate = average 10-year yield for the year. Period: 2010–2019. **Max Drawdown: maximum negative return for rolling 12-month period. Past performance is not a guarantee of future results.

Source: Bloomberg and J.P. Morgan, as of November 29, 2019.

 

 

The graph depicts the Sharpe ratio of the CEMBI (Corporate Emerging Market Bond Index) and select sub-indices. As one can see, the broad index as well as almost all sub-indices show returns in excess of volatility (i.e., Sharpe Ratio > 1). However, the CEMBI Index, which diversifies across countries, has a lower drawdown than the individual country components, reflecting a better volatility profile of the broad group of Emerging Market country corporate bonds, and which may result in similar if not better excess returns than any one country component.

Being aware of home-country bias is just one more hurdle to get over in forming a sound investment strategy. While there’s nothing inherently wrong with investing in the countries and sectors that one knows and loves, a global and diversified approach to portfolio construction can help clients achieve their investment goals through reduced risk-factor concentration, building a potentially more resilient portfolio overall.

 

¹ Emerging Market Corporates Sharpe Ratio 1.5 vs. U.S. HY 1.4, U.S. IG 1.3, S&P 500 0.9, as of November 2019. Source: J.P. Morgan Research.