Lacklustre UK performance makes international diversification vital
We are all being urged to shop local as part of a rescue package to save British high streets. The UK Government has pressed shoppers to visit their high street to support businesses stripped of footfall during pandemic lockdowns.
We’ll leave readers to draw their own conclusions about where and how they do their own Christmas shopping, but from an investment perspective, Shares believes that applying similar ‘local’ thinking to their investment strategy is a huge risk.
Recent headlines like ‘FTSE stages November rally’, or ‘FTSE hits nine-month highs’ might give the impression that UK equity markets have done OK this year, but the reality is a much less positive for UK stocks.
For example, in the year to date (to 7 December, at time of writing), the UK’s benchmark FTSE 100 has declined 13.8% even after posting its biggest monthly gain in three decades in November 2020. That means that £10,000 invested in Britain’s largest companies would have been whittled down to £8,620 this year.
Yet this horrid pandemic has not pulled the wheels off other markets. The S&P 500 has rallied 13.5% this year, Japan’s Nikkei 225 is up 12.2% and China’s Shanghai Composite is 11.6% ahead.
The MSCI World index, which measures the performance of approximately 1,600 companies from 23 developed nations, has risen 11.9%.
BLACK SHEEP OF GLOBAL STOCK MARKETS
The UK’s underperformance versus global stocks goes deeper than just 2020, it can be charted back to the Brexit referendum in June 2016, as the clouds began to gather over Britain’s economy and the potential fallout with Europe.
This can be demonstrated by looking at the stats for global equities after stripping out UK stocks. Since the end of June 2016 the MSCI World index has rallied 59%, versus the MSCI World-ex UK’s 62%. That three percentage point difference is down to the UK stock market and its poor performance.
It is true that the FTSE 100 may be dominated by companies that make much of their earnings overseas. Something like 65% to 70% of FTSE 100 profits are earned abroad, which should mean that the index is somewhat insulated from a downturn in the UK economy and provides a level of in-built investment portfolio diversification. Even so, that has not been enough to counter broader negative sentiment towards UK assets among international investors.
This makes diversification across international markets an important part of managing your risk. If the UK economy and stock market struggles, its declines should be cushioned by stronger performance elsewhere.
AVOIDING TOO MUCH HOME BIAS
Investors may need to overcome home market bias first. Research shows that most investors favour their own stock market, picking from a pool of companies with which they are most familiar.
But the standard financial-theory approach is quite different. This calls for investors to invest proportionally according to market capitalisation. ‘This method assumes that markets are reasonably efficient and that stock prices reflect all the available information, investment positions, and expectations of the investing community,’ says Brian J Scott, one of the authors of a research paper on diversification for Vanguard updated in 2017.
‘Investors in countries such as Japan, the UK, Canada and Australia would allocate less than 10% of their equity portfolio to their domestic stock market,’ the paper says.
This can be actioned easily by buying UK-based funds or investment trusts that put your money to work globally. There is also flexibility within this universe, so if you think US stocks look expensive right now, you can put more of your money in vehicles that invest elsewhere, such as China, Europe or global small caps,
The table shows some of the best performing funds in the Global category over the last five years. We have focused on products with annual charges of 1% or less.
The list confirms the reality that ESG (environmental, social and governance) linked investments are a coming force, with two of the funds having an explicit focus on sustainability.
The lowest five-year annualised return on the list of 18.3% is more than three-and-half times the annualised return from FTSE 100 tracking product iShares Core FTSE 100 (ISF) at 5%.