According to the 2017 Investment Company Fact Book published by the Investment Company Institute, investors’ capital in defined contribution and other retirement plans held $7.6 trillion or 56% in U.S. or global equity funds. Out of this $7.6 trillion, $5.9 trillion or 77% is held in U.S. equities. U.S. investors continue to exhibit a strong preference towards domestic securities, commonly termed “Home Country Bias.” There is not one exact method to get at the appropriate level of international exposure to have in one’s portfolio; however, there are generally accepted methodologies.
The most common methods are weighting by market capitalization and size of Gross Domestic Product (GDP). Under the market capitalization method, (depending on the index used) the U.S. equity market represents between 45% to 50% of the world. Utilizing the GDP method, the U.S. provides approximately 25% of the world’s GDP. Under these two methods, allocation to the U.S. would range between 25% to 50%. This is in stark contrast to the average allocation by U.S. investors of 77%. We are not recommending a range of 25% to 50% as there are other factors at play. For example, older individuals closer to retirement should have more U.S. exposure in order to reduce currency risk. However, we see this issue even with younger participants.
Due to the nature of defined contribution plans being participant directed, a retirement plan committee has little control in determining the participant population’s asset allocation and specifically geographic allocation. That said, there are steps the committee could take to, at a minimum, provide for opportunities to help steer participants toward having a more broadly diversified geographic exposure in their portfolios.
Selecting an appropriate Qualified Default Investment Alternative (QDIA). This is a powerful means to assist participants achieve greater geographic diversification, especially given current trends by participants increasingly concentrating their investments with the QDIA, in particular target date funds. Regardless of whether your Plan has selected target date funds, risk based funds, or managed accounts, be sure that your selection for this category is with a manager that has a well thought out investment philosophy towards geographic selection.
Investment menus that are well constructed will have numerous investment choices that provide exposure to international markets. We sometimes see menus that have a clear tilt towards offering many funds focused on the U.S. markets, with limited international options. As participants sometimes make the “1/n” mistake, having a disproportionate amount of U.S. investment choices and less international options leads to the problem of having too little geographic diversification. From our perspective, participants should be provided with a similar amount of options in the international space as domestic choices. The menu should have passive index options in international markets as well as active funds. Further, the active funds should provide some exposure to emerging markets and smaller companies. As noted in a previous blog post (Riding The Roller Coaster of Emerging Markets, July 18, 2017), we believe having some capital invested in emerging markets and international smaller companies is quite beneficial to long term success; however, we tend to prefer gaining exposure to those asset classes within a more broadly diversified portfolio rather than focused solely in those two areas.
Each participant has control over their portfolio. Participants, however, continue to focus their investments on U.S. assets likely due to familiarity and other behavioral biases. Hopefully, the two examples of possible solutions mentioned above will help committees think through the investment menu more thoughtfully. These solutions may help to mitigate the issue of lack of geographic diversification.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.