“Hard Brexit” fears have failed to keep UK equities from rallying, even as the pound has weakened to its lowest level in more than a century, according to the Bank of England. The FTSE 100, small-company focused FTSE 250 and MSCI UK all hit record highs in August and stand near those heights now. We aren’t surprised. The Brexit vote itself didn’t alter the relationship between the UK and EU. How the relationship looks after talks conclude will be more important, and that is quite uncertain. Perhaps the EU takes a hardline stance. Perhaps not. But if this is a concern of yours, we have a suggestion for you: Invest globally. Diversifying globally reduces the risk of being overly exposed to UK-specific risk factors, and provides a bigger slate of investment opportunities for your portfolio.
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Quite obviously, UK stocks haven’t done poorly lately. For the year, the MSCI UK is up a respectable 17%i. The rest of the world, however, is doing even better. The MSCI World Ex. UK Index (a gauge of developed world stocks outside the UK) has risen 26% so far in 2016ii. This isn’t just recent and tied to the pound’s decline, either. In the last two years, UK equities have substantially underperformed—non-UK stocks are up 45% to British stocks’ 18%, highlighting one potential benefit of global exposure for UK investors.iii
Exhibit 1: UK vs The Rest of the World, 2009 – 2016
Source: Global Financial Data, Inc. and FactSet, as of 12/10/2016. MSCI World ex. UK and MSCI UK monthly returns 9/3/2009 –12/10/2016.
Being confined to one category or country closes off opportunities. Similarly, a UK-only portfolio would not have benefitted from booming US Tech shares in the 1990s, and Japanese equities far outpaced the rest of the world during the 1980s. Now then, during the late 1970s, UK equities outperformed handily, rebounding from the deep bear market early in the decade as Margaret Thatcher’s reforms helped make Britain great again.
Should talks between the EU and UK devolve, British equities could underperform. We can’t forecast today how those talks will go, but they will likely drag on for years. Markets outside the UK are less exposed. This is a risk that is easily mitigated by investing globally. What’s more, many times, investors focusing on one nation unintentionally give their portfolios a lack of sector diversity too. UK markets are more heavily weighted in the Energy, Materials and Financials sectors (a combined 42% of the MSCI UK) than the global market (28% of the MSCI World). If these three sectors trail—as they have over the past two years—then an exclusively UK portfolio is poised to suffer.
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Exhibit 2: UK and Non-UK Leadership Rotates
Source: FactSet, as of 30/9/2016. Rolling 2-year returns for the MSCI World Ex. UK (with net dividends) and MSCI UK (total return) indexes, monthly, 31/12/1971 – 30/9/2016.
Given that, why choose to invest exclusively in a single country making up 7% of world market capitalisation? At times either UK or non-UK markets perform especially well whilst the other trails, and having a broad mix provides a smoother ride over time than investing solely in one area. A global portfolio would likely include UK stocks, but not exclusively. Hence it is more diversified and thus less subject to big performance swings.
Now, you may wonder: Why not invest globally, but heavily tilt the portfolio toward the region that’s leading, then switch to the other category when it leads? If it were possible to accurately forecast turning points consistently over time, then yes, this would be a winning tactic. Most investors don’t like seeing underperforming equities in their portfolio. It’s natural to want only what’s going up the most. Yet whilst we do believe region and country leadership can be forecast, timing it is imprecise—and you must always remember you could be wrong. Then, too, many investors fall prey to recency bias, chasing after the category that just did the best. If you load up on a hot category thinking it will continue to lead, your returns will suffer if that theory proves wrong. Repeating this error—by, for example, piling into US Tech in 1999 and then loading up on Emerging Markets miners in 2007—may risk not just underperforming, but not achieving your long-term financial goals. Staying global and retaining holdings even in areas you don’t think have as bright an outlook is exercising wise humility.
The implicit currency exposure of a global portfolio also offers diversification benefits. Just as no country’s equity market permanently outperforms, no currency does either. There will be times when the pound is weak, as it has been lately—boosting global returns—but there will also be times when it’s strong. Following a period of pound weakness after George Soros “broke the Bank of England” in 1992, sterling largely recovered by the late 1990s, contributing to UK equities’ outperformance relative to non-UK equities. Over time, currency movements—and their impact on global returns—should balance.
This doesn’t mean, though, that a global approach will always underperform a UK-centric one when the pound is strong. Currency movements aren’t the only factor influencing world equities and, as a result, there have been times when global outperformed alongside a strong pound. From 2014 – 2015, sterling was strong and non-UK equities outperformed.
Diversification reduces risk, but this also means not everything in your portfolio will do well at the same time. You’ll probably always have a portion of your portfolio you hate. It’s hard to appreciate sometimes, but that’s a good thing, not bad. In times like these when Brexit fears reign, we believe exposure outside the UK and the increased opportunity set that affords remains compelling.
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