Including global strategies in plan menus can increase diversification and investment opportunities.
Home bias (a significant over investment in one’s home country) has been a long-entrenched pattern in self-directed defined contribution (DC) plans. A decade of efforts by plan sponsors in the U.S., including the addition of international funds to retirement plan menus, has failed to successfully spur participants to increase their exposure to non-U.S. assets; the result is that participants are missing out on potentially attractive investment opportunities abroad, including in emerging markets. At the same time, plan sponsors are grappling with the phenomenon of choice overload, as more than a decade of behavioral finance research has shown that the expansion of menu options has proved overwhelming for participants, creating confusion and inertia.
We believe that reducing the number of menu options and replacing some with global strategies — encompassing the U.S., foreign developed markets and emerging markets — should help address choice overload and encourage more participants to allocate to non-U.S. markets. Offering global strategies in a simplified line-up should result in more diversified allocations by plan participants.
Plan Structure and Home Bias
Research has clearly demonstrated that the structure of a plan menu can strongly influence participants’ investment choices. Many plan sponsors have consequently tried to address home bias by changing the structure of their plans: increasing the number of international (purely non-U.S.) options in menus to encourage participants to allocate more to foreign markets. But this hasn’t worked. Although an overwhelming majority of DC plans offer at least one international option, many participants are choosing not to invest, or to invest very little, in them, even though most of the world’s market capitalization is outside the U.S. That small allocation to overseas markets stands in stark contrast to many defined benefit plans, which have increased their exposure to non-U.S. markets to access the increased investment opportunities abroad.
One reason for home bias is that many participants remain wary of non-U.S. capital markets. A 2015 survey found that even after the global financial crisis, 73% of investors remained confident in U.S. capital markets. Only 38% said the same about non-U.S. markets, however.1 Another cause of home bias is the human tendency to prefer the familiar— in this case, U.S. markets — over the unfamiliar.2 The home bias problem remains relevant for plan sponsors, as large numbers of participants are continuing to select their own investments despite the increased prevalence of target date funds and default options. Some participants may also be confused by the financial industry’s definitions of terms like “global” — meaning the U.S. plus other countries — and “international” — meaning developed non-U.S. markets. Although we feel that such definitions have a place in the financial industry, their distinctions are often lost on plan participants, who may see “international” and “global” as synonyms.
The Rise of Foreign Markets More than half of global market capitalization is non-U.S.
A Closer Look at Choice Overload
In a classic study of the impact of offering too many options, two finance professors set up two jam-tasting booths at a grocery store — one offering six varieties, the other 24. Although the 24-jam booth received more foot traffic, it made fewer sales than the booth offering just six jams. Consumers encountering more jam options ended up buying less.3
Similarly, a wealth of behavioral finance research shows clearly that too many DC menu options can lead to choice overload, resulting in participant inertia.4 Participant allocation decisions can also be influenced by the structure of the menu itself. For example, many participants choosing from a menu engage in naïve diversification strategies — splitting their money equally among the funds selected.5 They also allocate more of their money to equities when enrolled in plans that have a greater number of equity options.6 Research on choice overload has helped fuel the trend of automatic enrollment, automatic escalation and Qualified Default Investment Alternatives (QDIAs) in many 401(k) plans.7
Further demonstrating inertia, participants rarely revisit their initial allocation decisions. Nearly half of the participants in one major study made no active changes to their portfolio allocations over a nine-year period.8
The Best-Returning Geographic Areas for Equities Have Varied From Year to Year
Make DC Easy: Go Global
To address choice overload, many plan sponsors are looking to simplify their menus. We believe they should keep in mind the issue of home bias as they decide which options to retain, add or delete. Merely replacing some U.S. options with another international fund likely won’t do much to encourage participants to allocate more money overseas. As we have already noted, participants are tending not to invest or invest little in international funds despite their widespread availability.
We suggest that plan sponsors consider replacing some menu options with strategies organized under a "global” moniker for participants. As previously noted, participants can be confused by the industry terminology of “global” (U.S. plus other countries) and “international” (non-U.S. only). A global strategy — focused on the U.S., non-U.S. developed and emerging markets — is easier to understand than solely non-U.S. options introduced to participants as “international.”
In addition to being simpler to understand, global strategies also may encourage participants to allocate more to foreign countries. The reason is that the term “global” is all-encompassing. That tells participants that their “risky” non-U.S. allocation will be combined with some U.S. investments in a global strategy, reducing the perceived risk. A participant may not be willing to select a pure non-U.S. option like an emerging markets fund due to a lack of knowledge, a perception of risk, and familiarity bias. But participants may be more willing to allocate to a global strategy that could include the familiar U.S. as well as the quite unfamiliar emerging markets. Plan sponsors could emphasize this point in educational materials (see box below).
Educating Participants on Global
Appropriate participant education efforts can enhance the effectiveness of simplifying with global strategies. When describing these changes to participants, we recommend that plan sponsors:
- Emphasize that global strategies invest in both U.S. and non-U.S. markets.
- Tell participants that the fund manager believes that there are potentially attractive investment opportunities outside the U.S.
- Describe how in a globally integrated economy, products from companies like Nestlé can be found not only in Europe but in Southeast Asia and North America.
Global: A More Modern Approach to Asset Allocation
Global strategies also better reflect today’s economic reality than the traditional division of assets into U.S. and non-U.S. categories. Using the modern portfolio theory rationale, international options were added to DC plan line-ups to increase diversification. However, where companies do business has become increasingly disconnected from where they’re headquartered. The figure below shows how the 10 largest European companies derive more revenue from emerging markets than their own region.
The world is undergoing what we call the great global rebalancing — economic demand is shifting to the emerging markets, and both U.S. and non-U.S. companies are meeting that demand. As a result, it is more important today to think of companies that can be the winners over the long term by meeting those needs in a timely and cost-efficient way. A global strategy allows managers to invest in the best companies regardless of where they are domiciled. It is a strategy unburdened by geographic limitations.
Global strategies also make sense in light of behavioral finance research. Managers of defined benefit plans can dynamically reallocate among non-U.S. and U.S. strategies to seek to take advantage of changing economic conditions. In contrast, many DC participants go for years without making any changes to their investment options. As a result, even if participants were to invest in non-U.S. funds, they likely would fail to adjust their allocations to reflect changing economic realities.
Companies Aren’t Confined to the Region They’re Headquartered In.
Revenue Exposure of Top 10 Companies in the MSCI Europe Index
Sources: MSCI, RIMES. Revenue exposure of the top 10 companies in the MSCI Europe Index by market cap, as of December 31, 2015.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
Implementing Global in a Simplified Plan
There are a variety of ways a DC plan sponsor could include global strategies in a line-up. Sponsors could replace two or more options with a single global strategy. This would reduce the number of menu options — addressing choice overload. In addition, global strategies, as previously noted, can encourage participants to gain more exposure to foreign markets while also allowing managers to seek the best investment ideas free from geographical constraints. Simplifying a plan with global strategies can also free up room on the menu for the introduction of other asset classes like real assets and alternatives.
Plan sponsors could also eliminate some options and then fully substitute global strategies for all remaining choices — reducing the menu and converting it entirely to global strategies. Alternatively, a plan sponsor could simply add a global strategy to an existing plan. Although adding another option to a plan could potentially aggravate choice overload, it could result in more participants allocating to foreign markets.
Each of these approaches has potential advantages but requires careful consideration by plan sponsors, who are in the best position to know their participants’ needs.
Active Management of Global Strategies
We believe that active management is the best way to take advantage of the full range of opportunities that exist in global markets. The MSCI All Country World Index consists of about 2,500 companies. With so many choices of companies and countries, security selection becomes even more important. An ideal global strategy manager would have:
- Global resources and experience.
- A long track record in global strategies.
- A wide variety of global strategies to address different investment objectives.
- Reasonable and transparent fees.
Global as a Gateway to a Smarter Lineup
As plan sponsors look at reducing their lineups to address choice overload, they should consider global strategies. By informing participants that their non-U.S. exposure will be combined with a U.S. allocation, global strategies can encourage investors to invest more of their money in foreign markets, thereby reducing the home bias that has kept many participants from benefiting from potential investment opportunities abroad.
In addition, global strategies better reflect the reality of globalization. The increasing interconnected nature of global markets are making the traditional U.S./non-U.S. allocation split less relevant. Global strategies take advantage of this new environment by searching for the highest conviction ideas independent of geographic constraints.
Global strategies also can flexibly fit into a revamped lineup. As they consider global strategies, plan sponsors should keep in mind the benefits of active management in this area.
The Capital Organization: Leaders in Global Investing
We are committed to helping defined contribution (DC) plan sponsors meet participants’ needs. We offer:
- A diverse set of global strategies in both equity and fixed-income.
- More than 30 years’ experience working with DC plans.
- A range of strategies for all stages of the savings cycle.
- Extensive global research.
- Experienced professionals with a long history in the organization.
- A long-term focus.