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Regardless of where they live, investors have a significant opportunity to diversify their equity portfolio outside of their home market.

Regardless of where they live, investors have a significant opportunity to diversify their equity portfolio outside of their home market.

Despite the opportunity, investors typically maintain a significant home bias – higher allocations to their home country than the market capitalisation weight these represent in a global equity index.
Australian investors have tended to build portfolios that are highly concentrated in the domestic equity market. The Australian market has on average represented roughly only three per cent of the MSCI World Market Cap Weighted Index.
This piece examines how a portfolio predominantly allocated to Australian equities (proxied by the MSCI Australia Index) stands to benefit from a greater breadth of global opportunities (proxied by the MSCI World Index).

Global equities provide exposure to a diverse range of countries, sectors and industries which can serve as a hedge against specific country, sector or industry risk. Australian equities are highly concentrated at both the sector and individual security level.
The financials and materials sectors alone constitute nearly 60 per cent of the Australian equity market compared with 20 per cent globally. Diversifying exposure globally provides investors the opportunity to participate in regional markets which are performing differently, thereby further diversifying sources of risk and return.

In the Australian market, financials and materials are heavily represented in the top holdings within the MSCI Australia Index, with the largest top 10 stocks, comprising over 50 per cent of the index.
Furthermore, the top five stocks comprise more than a third of the index while the bottom third of the index is comprised of 55 stocks

Anchoring stock selection and portfolio construction purely to the Australian equity index increases overall risk exposure. By leaving investors reliant on only a handful of return drivers, Australian indices expose investors to higher volatility and more frequent drawdowns than better diversified global indices.
Due to the concentrated nature of the Australian equity market, over the trailing 10-year period, Australian equities have realised over 30 per cent more volatility and, on average, over 60 per cent greater drawdowns

An allocation to global equities would have significantly improved both risk and return over the trailing 10-year period.
A portfolio comprised of 75 per cent global equities and 25 per cent Australian equities would have realised 30 per cent less risk over this period compared with a portfolio comprised of 100 per cent Australian equities.

In addition to the increase in volatility in drawdowns experienced by the home bias investor, there has been substantial opportunity cost associated with lack of global index exposure.
Even in those calendar years where the MSCI Australia Index has outpaced the MSCI World Index based on total return, the vast majority of top performing stocks were based outside of Australia, underscoring the opportunity a global manager has to potentially add additional alpha to a purely (or largely) domestic Australia portfolio.
In all years since 2009, nearly 100 per cent of the top 50 performing stocks in the MSCI World Index were domiciled outside of the Australian market. 

The scope and diversity of the global equity market makes fertile ground for active managers. Data on Alpha by international managers bears this out. The median and top quartile Active managers earned significantly more Alpha for their clients as compared with those constrained to the US market. 

The global income drought means investors no longer have the luxury of staying home. With Australia comprising only 2 per cent of global equity markets, investors would be foolish to constrain themselves to the domestic market alone. 
Mike LaBella is head of global equity strategy at QS Investors