If your funds behave in the same way, you could find yourself in keep water if your base case for investing is proved wrong. Tech-heavy investors in the late 1990s will know all too well that everything going up together isn’t always a good thing…
To mitigate this risk, equity investors have increasingly diversified their UK exposure with global and regional funds. This approach makes sense, especially for equity income investors, as the UK dividend paying market has historically been very concentrated with the vast majority of funds deriving the bulk of their income from a handful of stocks such as GlaxoSmithKline, AstraZeneca HSBC and Royal Dutch Shell.
When everything is going to plan that’s fine, but as BP’s dividend cut after the 2010 oil spill illustrated, it pays to have your eggs in more than one basket.
Performance of stock versus sector in 2010
Source: FE Analytics
It’s not as easy as simply holding a global fund however; FE Analytics shows that investors who even hold a variety of funds to diversify their income stream may not necessarily be spreading their bets effectively.
A crude example is looking at an investor who holds a UK equity income fund that’s 100 per cent invested in equities – for example Jeremy Lang’s Ardevora UK Income portfolio – with a top-performing Global Equity Income fund like Liontrust Global Income.
If investors were to split their capital equally between the Ardevora and the Liontrust funds, FE data shows they would still have 75 per cent of their money in the UK equity market. In that scenario, an investor would only be holding 13 per cent in European stocks and 5 per cent in North America.
Investors in these funds would also be doubling up their stock exposure in a number of UK companies. British Sky Broadcasting Group, for example, makes up at least 4 per cent of each fund.
Our data shows that the correlation between the funds has been just 0.86 over the past three years – deemed “very high” by FE Analytics.
Performance of funds over 3yrs
Source: FE Analytics
An equally weighted portfolio of the two has had a correlation of 0.93 per cent to the FTSE All Share over three years. This figure is higher than that of a number of UK Equity Income and UK All Companies funds.
That is an extreme example of course – the Liontrust Global Income fund holds 50 per cent in the UK, and is a former member of the UK sector. However, the study goes to show the importance of knowing what’s under the bonnet of your funds.
Indeed, even if you look at the average UK Equity Income fund and the average Global Equity Income fund, the UK exposure is very high. An equally weighted portfolio of the two sector averages would have 53 per cent in the UK, 18 per cent in North America and 13 per cent in Europe. Contrary to what some investors might expect, exposure to Japan and emerging markets is minuscule.
Looking at another extreme, it’s possible to get yourself into a situation where you have more exposure to an international market than you’d want as IMA UK Equity Income managers are permitted to invest 20 per cent of their fund outside of the UK.
FE Alpha Manager Neil Woodford is renowned for using his overseas allocation and many expect him to have sizeable weightings to non-UK stocks – particularly European pharmaceuticals Roche and Novartis – in CF Woodford Equity Income.
His successor on the Invesco Perpetual High Income and Income funds, FE Alpha Manager Mark Barnett (pictured), has retained 17 per cent of international exposure, split between the US and Europe. Newton Higher Income, Schroder Income, Liontrust Macro Equity Income and Evenlode Income also have less than 85 per cent in the FTSE All Share.
Using the portfolio tool on FE Analytics, we can see how these weightings impact a “diversified” portfolio.
An investor with an equal split between Invesco Perpetual High Income, Fidelity Global Dividend and Blackrock Continental European Income, for example, would have more than 50 per cent exposure to Europe ex UK.
Getting more exposure to the US than you banked for is even more likely, as North America makes up more than half of the MSCI AC World index.
An equal split between M&G Global Dividend [52 per cent in the US], Schroder Income [12 per cent], Neptune European Income [3 per cent] and JPM US Equity Income [100 per cent] – would result in a portfolio with 43 per cent invested in the S&P 500.
This apparently diversified portfolio has a correlation of 0.86 to the S&P 500 over the last three years – again, “very high” according to FE Analytics.
Performance of composite portfolio vs index over 5yrs
Source: FE Analytics
While funds within the study have been cherry-picked, investment manager at Equilibrium Mike Deverell (pictured) says it goes to show why investors need to do their own homework when they construct their portfolio.
“It’s very much about looking under bonnet with these things,” Deverell (pictured) said.
“All sectors allow funds to invest 20 per cent of their assets outside of their specified remit and that is something we find really difficult when we are building our portfolios.” He adds that looking at sector diversification is equally important.
“Most equity income stocks will be in a select number of sectors,” he said. “If tobacco and utilities are the dividend paying sectors in the UK, the chances are they will be the highest paying dividend sectors in the US or Europe.”
“You have to be very careful, as diversifying by regions isn’t the be all and end all.”
FE Trustnet will look at global funds that have the lowest correlation to the UK market in an upcoming article.
Later today, we will look at other ways investors can measure the riskiness of funds.
