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Why your “diversified portfolio” probably isn’t that diversified

09 January 2015

Data from FE Analytics reveals that while most investors’ portfolios may be diversified in terms of holdings, they are still likely to move up and down together at the same time.

By Alex Paget,

Senior Reporter, FE Trustnet

Investors are often told that the key to a successful long-term portfolio is diversification, effectively making sure they don’t have all their eggs in one basket.

It is fair to say that most investors will use UK funds, be it a growth or income fund, as their core exposure to the equity market then to try and make sure the fate of their savings isn’t at the mercy of the FTSE All Share’s performance, they will use global funds for the purposes of diversification.

This makes sense, given that the large majority of funds within the IA Global and Global Equity Income sectors have a low weighting to the UK market.

That being said, data from FE Analytics shows that just because investors use global or even regional funds to sit alongside their UK exposure, it doesn’t mean that their holdings won’t move up and down together at the same time.

For this article, we used the correlation table on FE Analytics – which calculates how in line two items have moved together in the past. Funds, sectors or indices with correlation of 0.7 to 1 are highly correlated, between 0.7 and -0.3 are lowly correlated and between -0.3 and -1 are negatively correlated.

While we know the past is no guide to the future, we based the performance over five years as that period now incorporates a number of rising and falling markets.   

Source: FE Analytics 

According to FE Analytics, the average fund in the IA Global and IA Global Equity Income sectors has had a very high correlation to the FTSE All Share of 0.9 and 0.91 respectively over the last five years – suggesting they don’t offer UK investors a huge amount of diversification.

The reason for that is how they are positioned. The average fund in the IA Global sector has more than 60 per cent spread across the US and Europe, which as the table shows, are also quite strongly correlated to the UK.

IA Global Equity Income has around 55 per cent in those two markets and 16 per cent in the UK. However, the major caveat to that is investors who turn to global equity income funds are often looking to diversify their dividend stream away from the concentrated UK market, rather than diversifying their total return.

Nevertheless, FE Analytics shows every fund in the 33 strong-global equity income sector has a correlation of more than 0.7 to the FTSE over the last five years.

The two portfolios which have been the least correlated to the UK over that time – at 0.83 – are James Harries’ £4.4bn Newton Global Higher Income fund and Bruce Stout’s Aberdeen World Equity Income fund.


The Newton offering has delivered the highest return out of the two over five years. Its gain of 56.25 per cent places it in the top quartile of the sector, while Aberdeen World Equity Income’s returns of 26.07 per cent mean it has been the worst performing portfolio in the sector over that time.

As a point of comparison, the FTSE All Share has gained 45.37 per cent over five years.

Performance of funds vs sector and index over 5yrs



Source: FE Analytics 


However, both funds have underperformed against the MSCI World and FTSE World indices over the period.

Obviously, given that global financial markets are so intertwined and have largely been at the mercy of central banks since the period of the financial crisis, it is very unlikely to find an equity market which is negatively correlated to the UK.

However, there a number which are quite lowly-correlated, such as the IA Japan sector at 0.39 over five years.

Every fund within the sector has a low correlation to the FTSE All Share over five years. The most extreme examples have been CF Morant Wright Nippon Yield with a correlation of 0.14 and Legg Mason Japan Equity, which has had a correlation of just 0.07 over that time.

However, the average fund in the IA Japan sector, with its returns of 33.4 per cent, has underperformed against the FTSE All Share by more than 10 percentage points over five years and has been more volatile.

Mike Deverell, investment manager at Equilibrium and member of the AFI panel, says correlation is an important aspect of building a portfolio and warns that though investors might have diversified holdings if they choose a global fund to sit alongside their UK fund, they must realise both are likely to move up and down together most of the time.

He says, however, the chances are that investors aren’t going to find truly uncorrelated assets within equity markets. While he says investors should be aware that their global or regional fund won’t necessarily act differently to their UK fund, it all comes down to their individual preference. 

“Correlation is important as you want your portfolio to be as diversified as possible,” Deverell (pictured) said. “However, you have to recognise that global equity markets will be quite highly correlated and so it is your asset allocation is what will drive uncorrelated returns.”

However, Deverell says if they want lowly correlated equity returns within their portfolio, investors in UK funds should shy away from other western economies should look towards regional areas of emerging markets.


He says that not only have they historically been lowly correlated, but they should “boost returns” for investors over the longer term.



Source: FE Analytics 

According to FE Analytics, the likes of the MSCI India, MSCI Frontier Markets, MSCI China, FTSE ASEAN, MSCI Russia and MSCI Latin America have all been lowly correlated to the UK equity market over the last five years.

The FTSE ASEAN index and the MSCI Frontier Markets index have both outperformed the FTSE All Share over that time, while the other four indices have all underperformed.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.