According to a recent paper authored by Vanguard’s research group, U.S. investors have close to 80% of their equity exposure in U.S. stocks, even though the U.S. stock market accounts for only about 51% of the total market capitalization of global equities (data as of December 31, 2014). While there may be good reasons at times to have such a home country bias, and those reasons are explored in the paper, we question whether or not this is one of those times. In fact, by most measures, U.S. equities look expensive relative to their European and Asian counterparts, both developed and emerging, as can be seen in the following table.
On top of that, U.S. companies are carrying higher debt levels, and while that has helped U.S. firms to post higher returns on assets, equity and invested capital, those days could be numbered as rates start to increase.
Further, while most U.S. investors have a fairly clear picture of their long-only equity allocations, the same may not be true for exposure gained through long/short equity funds. This category of funds is quite heterogeneous, and Morningstar doesn’t divide up the group by market cap, style and geography, as is the case for long-only funds. So what does the geographic exposure of long/short equity funds look like? Perhaps not surprisingly, this group of funds also exhibits meaningful home country bias in aggregate, with slightly more than 80% of their long exposure invested in U.S. stocks, and a still healthy 51% of their net exposure in U.S. stocks, according to the most recent portfolio data available at the time of this writing.
Long/short funds as a group exhibit an even more pronounced home country bias than is the case with U.S. equity investors as a whole, when you consider that the ratio of U.S. net exposure to non-U.S. net exposure is close to 6x when using the averages and almost 15x using the median figures. In contrast, U.S. investors prefer U.S. stocks in a ratio of about 4 to 1.
Point being, whether you believe that U.S. stocks are expensive on an absolute basis, as we’ve explored previously, or on a relative basis, as we’ve attempted to demonstrate here, adding long/short equity exposure that is diversified globally could be tremendously beneficial should the U.S.-led bull market start to pull back from its lofty levels. At the very least, investors in long/short funds should understand the geographic exposure contained in their portfolios and think about how that complements (or not) their long-only equity exposure.
Read our related blog, Extreme Valuation in the Time of Indexing