UK Home Bias
There is a tendency for investors to favour allocations to their home equity market and this can disproportionately skew investment risk within a portfolio. There are many reasons why investors adopt such an approach (some of which are compelling), but ultimately, we believe that it is important for portfolios to be globally diversified in exposures to all asset classes. The UK equity market represents only 5.6%[1] of the MSCI AC World Index by market capitalization and yet allocations within investment portfolios can often represent sizable multiples of this percentage weighting. What are the reasons for this and how can we ensure that behavioural biases do not detrimentally impact client outcomes?
Global diversification avoids the risk of portfolio returns being derailed by a country specific market/economic event (e.g. Brexit). Diversification is particularly relevant in a mature market like the UK, whereby relying on UK equities, means that you are not directly exposed to the fastest growing economies. Whilst globalisation has resulted in greater correlation within global markets, there are still opportunities to benefit from global markets that stand at differing stages of the economic/market cycle. As such, when the UK market is in a state of uncertainty around Brexit outcomes, there are other parts of the world with a more solid economic backdrop which can help to drive returns.
It could be argued that there is sufficient exposure to global economies through the FTSE 100, where more than two thirds of revenues in the underlying companies come from outside the UK. However, the make-up of the UK equity market reveals certain sector biases. By focusing on this market, portfolios end up with risk skewed towards certain industries and sectors of the economy. For example, the UK market has a heavy bias to energy and consumer staples companies. Conversely, the UK market offers less opportunity to tap into specific growth areas such as technology. The dominance of certain sectors within a portfolio can result in greater volatility.
One important consideration is currency risk. When investing in overseas equities, changes in the rates of exchange between currencies may cause investment/income values to fluctuate. It is sensible for a UK based investor (with future liabilities in sterling) to have a sizable allocation to home markets. However, for some investors with substantial UK assets (including property and UK businesses) there may be scope to tilt an investment portfolio a little further towards global markets/assets.
Whilst an allocation to global markets will improve diversification risk, one stills need to be mindful of additional risks in some regions. Of course, geopolitical risk can be a feature of all individual global markets at one time or another, but it has more frequently been a primary concern for emerging market investors and therefore we should ensure that exposure to these particular markets are sized according to the overall risk profile of the client.
So, what does this mean for Five Wealth client portfolios. We would not advocate taking a market cap approach to asset allocation. We do however believe that “home bias” should be one of the factors we consider within a holistic approach to portfolio construction and risk management. A useful reference point might be to consider how the MSCI WMA Private Investor Indices balance the allocation between UK and international equities. This provides a snapshot, reflective of the industry’s current asset allocation views across a range of multi asset portfolios.[2] Whilst our firm aims to take long term strategic asset allocation decisions, our investment committee will also form a tactical view of the prevailing risks/opportunities in various asset classes, sectors and geographies and these will feed through to the ongoing management of client portfolios.
The value of investments can fall as well as rise and you may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Investing in shares should be regarded as a long term investment and should fit your overall attitude to risk and financial circumstances.
[1] https://www.msci.com/documents/1296102/1362201/MSCI-MIS-ACWI-May-2018.pdf/2eda5573-4e0c-56f9-b3ca-d6b3eb3552e7