Investors driving outflows from UK equity funds may be missing a key point.
Namely that UK equities’ declining correlation with global equities is making them a powerful diversifier.
Granted, US and world equities have persistently outperformed the UK equity market from a returns perspective. But from a diversification perspective, UK equities have a useful role to play.
Getting proper diversification
For asset allocators looking to build-in diversification by having different global or US equity funds from different providers, this provides little no diversification from a risk perspective as they are so highly correlated.
Correlated funds will move broadly in tandem, regardless of which active manager or style it is, and regardless as to whether its active or passively managed.
But pairing a global or US equity fund with a UK equity fund introduces true (risk-based) diversification within the equity portion of a portfolio because of the UK’s low correlation and very different and sometimes opposite return pattern.
Recall 2022, the inflation shock from the Russia/Ukraine war and related sanctions meant that the UK equity market was up, when the US and hence world equities were down.
Similarly, this year the UK equity market has frequently moved inversely to the US and world equities in January, April, June and July. It has actually been a source of portfolio resilience.
The power of correlation
By combining lower correlated assets, the risk of the portfolio whole can be less than the sum of parts.
Looking at long-run 10 year historic data as at end 2023, the US and UK correlation to world equities is 0.97 and 0.80 respectively.
But looking at short-run one year data to end July, the US is still 0.97, but the UK is far lower at 0.61.
Short-run UK equity correlation with world equities has visibly decoupled from world equities. Prior to 2015 UK and US equities were similarly correlated to world equities over the short-run.
We then see two clear periods of material disconnect. One following Brexit and the second following Covid and subsequent related inflation shock and the marked by divergence between tech-oriented US market and value-oriented UK market.
How much to have in UK equities?
UK discretionary managers of a typical “balanced” portfolio have shifted from having 70 per cent of the equity allocation in UK equities back in 2000 to just 33 per cent in UK equities today, according to our research.
Global equity indices are less generous. The UK equity market’s index weight has shrunk from approximately 10 per cent as recently as 2011 to approximately 4 per cent today.
The shrinkage is a function of simple maths. A far greater number of the rest of the world’s listed companies (predominantly the US) have grown their earnings (and hence market capitalisation) far more than the UK’s listed companies. As a result, the UK’s relative size has shrunk.
Twenty’s plenty
In our work with UK financial advisers and wealth managers, we found a range of opinions. We have always considered a UK equity allocation of 30-50 per cent to be too high, even though that was often the existing default for firms using either third party asset allocation models or asset allocation benchmarks overseen by the UK’s largest wealth managers.
Whilst intellectually we can (and did) make the case for no home bias, we found that many adviser firms (and indeed their end clients) would be more focused on the FTSE 100 and would want and expect to see a range of UK-focused funds in a portfolio.
On this basis, we alighted on a target 20 per cent UK equity allocation as a mid-point between a “high” bias of 40 per cent or so and no bias (the UK’s global equity index weight).
We incorporate this 20 per cent home equity bias into our multi-asset indices that can be used to evaluate multi-asset portfolios and multi-asset funds.
Crack out the (English) sparkling wine
The UK’s reduced correlation with world equities should be a topic of celebration for asset allocators: it means an allocation within an equity portfolio to UK equities creates genuine diversification which improves portfolio resilience.
Whether that UK allocation is implemented with an active fund, index fund, yield-focused fund or mid-/small-cap fund (or a mix of the above) is then a secondary decision.
From a sizing perspective, we think within equities, that twenty is plenty for the UK, and interestingly the proposed £5,000 UK Isa Allowance would also make up 20 per cent of a total £25,000 Isa contribution.
UK equities have a useful role to play within multi-asset portfolios – but primarily from a diversification perspective.
Henry Cobbe is head of research at Elston Consulting
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