THE debate about how big or small we want a future Australia to be is set to rage between now and the next election.
While the political debate is focusing on our population growth and infrastructure to support a projected population of 40 million, there is another dimension to the small versus big issue that from an investor’s perspective goes to the heart of the basics of portfolio construction and managing portfolio risk.
If you look at the Australian sharemarket as measured by the S&P/ASX 200 index, it has a market capitalisation of $1.1 billion and from an individual investors’ perspective, that is a big market.
Yet on a world scale our sharemarket is a minnow when lined up with other major developed economies, like the US and Europe. The S&P Global 1200 index, a composite of seven regional indices that covers 29 local markets, has a market capitalisation of $US22 billion by way of comparison.
Now a portfolio bias to your home country is both natural and sensible when it comes to investing. For a start, local knowledge of markets and companies will be deeper and better informed compared to other world markets. Then there are pragmatic tax influences – our dividend imputation system in particular – that makes Australian shares more attractive on an after tax basis. Finally, there is the currency factor which adds considerable risk and volatility when investing offshore.
And investors have been well-rewarded in recent years for investing in the Australian market – our economy has weathered the global financial crisis better than almost any other developed country – so it might seem counter intuitive now, as economic indicators are increasingly sending out positive signals to be questioning the portfolio allocation to domestic shares.
But if you take a high level view of the Australian sharemarket – let’s call it the space shuttle perspective – the picture changes somewhat.
Our sharemarket is dominated by two key sectors – financial stocks (excluding property trusts) at 33% and the materials sector at 25% which is where you find all the mining companies. So from a portfolio construction viewpoint an investment in the Australian sharemarket is getting a heavy exposure to banks and mining companies.
You only need to look at the top 10 companies in the index –BHP Billiton and the four big banks are the top five – to see that clearly. And our market is quite concentrated with the top 10 holdings accounting for almost 52% of the market capitalisation.
When you contrast the Australian top 10 stocks with the top 10 companies in the S&P Global1200 index you see quite a different mix of companies and economic activity: Exxon, Microsoft, Apple, General Electric, Bank of America, HSBC, BP, Nestle, Proctor & Gamble and JP Morgan Chase.
And significantly from a risk perspective the top 10 only represents 9.2% of the total index capitalisation and the single largest company (Exxon) represents less than 1.5%.
Naturally, diversifying across the world’s developed sharemarkets lowers your specific security risk but also gives you access to some of the world’s leading companies and the ability to share in their growth and innovation – think Apple’s iPad for example. Importantly, international shares in a portfolio reduces the concentration risk inherent in our domestic market.
It is conceivable that the events of recent years will have reinforced the natural home country bias, because investors have been well-rewarded by keeping their money at home. And no-one is predicting an end to the mining boom any time soon.
But over the long-term, we know markets move in cycles and that rebalancing a portfolio from a risk and diversification perspective is one of the investing disciplines that help investors stay on track.
Any investment overseas needs to factor in currency risk, but the next time you review your portfolio’s asset allocation the question of how much should be invested internationally is a timely one to ask.
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Robin Bowerman, Vanguard Investments Australia's Head of Retail, has more than two decades of experience in the finance industry as a writer, commentator and editor.