UK investors significantly increased their risk appetite during the final quarter of 2016, according to the latest research from Natixis, but the firm warns that a greater emphasis should be placed on currency risk.
The quarterly Portfolio Barometer report, which is based on 108 model portfolios from 23 UK financial advisory firms, analysed 30 ‘Conservative’, 39 ‘Moderate’ and 39 ‘Aggressive’ offerings and focused on how their positioning changed between Q3 and Q4 last year.
Among the ‘Moderate’ and ‘Aggressive’ portfolios, there was a notable shift out of global and UK large-cap equities into risk assets that are further down the cap spectrum. However, while the ‘Cautious’ portfolios significantly reduced their fixed income weightings, this generally went into upping their cash weightings.
James Beaumont, international head of portfolio research and consulting at Natixis, said: “‘Risk on’ seems to have been the mantra of the final quarter of last year. In fact, the net effect over the quarter was positive for risk, specifically developed market equities, and negative for bonds.
“An important point for UK investors to keep in mind in the current environment is to factor in the impact that currency risk can have on their portfolios. Looking at the data for last year, we can see how significantly portfolios benefitted from holding non-sterling assets as the pound depreciated following the Brexit vote in June 2016.”
Following the EU referendum in June, sterling plummeted in value, which bolstered large-cap, global-facing exporters while domestic stocks were given the cold shoulder.
However, the election of Donald Trump as US president last November - combined with UK chancellor Philip Hammond’s Autumn Statement – unveiled plans for fiscal expansion and boosted investors sentiment. This led to an aggressive rotation out of quality growth stocks and into value and more cyclical plays.
Performance of indices in 2016
Source: FE Analytics
Bond yields, having reached historic lows earlier in the year, also rose sharply as investors feared that inflation could eat into the value of their coupons.
These overarching trends closely correlate with Natixis’s latest report; the data shows that ‘Cautious’ portfolios reduced their fixed income weighting by an average of 11 per cent. ‘Moderate’ and ‘Aggressive’ portfolios also sold down their fixed income weightings by 3 per cent and 1 per cent respectively.
In contrast, all three model portfolios increased their equity weightings to varying degrees and have all increased their cash weightings. While this was by just 1 per cent in the ‘Moderate’ and ‘Aggressive’ portfolios, the ‘Cautious’ portfolios upped their cash weighting by 8 per cent over the course of Q4 last year.
“Breaking down segment changes within the fixed income sector in ‘Conservative’ models, sterling fixed income saw a decrease by more than 7 per cent,” the report states.
“Allocations to inflation-linked bonds were reduced by more than 2 per cent, as was global fixed income exposure, collectively accounting for most of the change at the broad category level. This reduction in fixed Income appears to have increased money market exposure and, to a smaller degree, increases to allocation and alternative exposures in the models.”
In terms of equities, the rotation into small-caps, combined with an increase in alternatives and a reduction in property exposure, suggests to Natixis that ‘Moderate’ and ‘Aggressive’ portfolios are upping their risk tolerance.
Notably, both portfolio types increased their exposures to UK, US and Japanese small-cap equities.
“The allocation into Japan is intriguing,” the report continued. “In 2016, Japanese equities lost 2 per cent in yen terms, but would have actually risen some 21 per cent when considering the significant fall in sterling and when the Brexit referendum result is factored in.
“Two decisions are now evidently required by investors when investing in Japan – a decision on the equity market itself and a decision on how to handle the currency risk. This dual decision is an example that can be applied to investing in the US, Europe and other countries when considering, typically, unhedged equity investment.”
Performance of index in GBP and JPY in 2016
Source: FE Analytics
When it comes to overarching trends, Natixis points out that, even if investors were able to accurately predict the UK would vote to leave the EU, that Donald Trump would win the presidential election and China’s corporate credit market would come under pressure, they certainly wouldn’t have expected market returns to be as positive as they have been.
While this is good news for those already invested, the report points out that gains have been made with significant levels of volatility along the way across regions and asset classes.
Hefty currency movements have also contributed to this and, from a UK perspective, the report finds that most model portfolios left equity exposure unhedged but hedged fixed income exposure.
This has indeed been lucrative for UK investors over the last financial quarter of 2016. However, Natixis warns that the volatility we experienced in currency last year should act as a red flag to investors when it comes to how much risk they are really taking on.
Matthew Riley, head of research of the portfolio research and consulting group at Natixis, said: “From a UK perspective, the most significant decision for an investor last year was how much currency risk to take, either intentionally or unintentionally.
“Specifically, holding non-sterling assets, unhedged, would have significantly benefitted UK investors but currency volatility is notoriously difficult to predict and some form of hedging may be advisable for investors going forward.
“Although the year-end numbers for various market returns ended on a positive, there was significant volatility on the path they took to get there – across asset class and region. As a result, it is important for investors to understand all of the risks in their portfolios and, where necessary, seek to mitigate these.”