The benefits and risks of asset allocation

Globe with investing graphs and paperwork

Most UK investors have quite a hefty slice of UK holdings in their portfolios: they may make up the bulk or even the entirety of their investments.

So what is it about the UK that gives it pride of place in British portfolios? Is it the appeal of familiarity: a knowledge of UK companies and a readily accessible stream of news about them? Is it down to economic stability?

Darius McDermott, managing director at Chelsea Financial Services, says many people who come to him are overweight in the UK, while ignoring countries such as the US, despite the fact that returns there have been good recently.

'Our clients tend to have a big overweight to the UK, some Europe and some US. If they want a bit of risk, they tend to go to Asia or emerging markets,' he says. 'UK investors are cautious, and a solid Woodford equity income fund seems to carry less risk than a US tech fund. There is an over-dependence on the UK. People should probably have more broadly diversified portfolios.'

DIVERSIFICATION

Indeed, Money Observer speaks to many investment experts, and a lot of them say UK investors, even the more sophisticated ones, tend to be too heavily weighted towards their home country.

The big drawback to this arises from a basic principle in investing: diversification. If a significant slice of your portfolio sits in UK holdings, what happens if the UK hits hard times?

What happens to your typical equity income fund or investment trust, for example - given the large concentration of financials in the FTSE 100 - in the event of another banking crisis?

'Lots of people who own equity income funds have a concentration in five or six companies. That means the source of their income is fairly concentrated as well,' says McDermott.

It's all well and good to champion the benefits of diversification, but it's important to also consider the risks of taking your investments abroad.

The single biggest risk is currency risk. Fluctuations in exchange rates mean that if you invest using a currency other than sterling, you might find that a weakening exchange rate relative to sterling detracts from the returns you actually receive, even if the investment itself has done well.

Exchange rates add another moving part to the buying and selling of investments in an already unpredictable environment.

Beyond the developed world, you face a whole slew of other risks. You get real geopolitical risks in emerging and frontier markets. Will corruption scandals hurt markets? Will there be a revolution? Will the country be invaded? Will it lose control of inflation?

Regional choice is complicated by other considerations. 'There are about 180 countries in the world,' says Wouter Volckaert, manager of the Henderson Global Trust.

'Roughly 20 are classified as developed, 20 as emerging and about 140 as frontier markets. Frontier markets are very difficult to invest in. In frontier market countries there are about five stocks with liquidity of more than $5 million [£3 million] a day, so you can't put big amounts of money into these countries.'

If you want to gain broad global exposure, including exposure beyond emerging markets, therefore, you might find liquidity and accessibility quite a challenge. In emerging and frontier markets, corporate governance at company level can also be a problem, as can a lack of broker analysis, particularly for smaller companies.

The other big stumbling block is income. The UK has historically been a very reliable source of income in the form of dividends. If income is what you're after, why look elsewhere?

KNOW THE RISKS

Before we examine these risks, it is worth pointing out that you may already have more UK or international exposure than is immediately obvious.

Consider the rest of your assets, including your pension and property. Your home and any other UK property you own is already exposed to the UK economy, while your pension funds are also likely to be skewed to the UK.

On the other hand, if you invest in the FTSE 100, many of the companies you might hold are likely to be exposed to international markets. A study published in 2014 estimated that a staggering 77 per cent of FTSE 100 revenue was generated overseas.

Now let's consider currency risk. Is currency risk actually something to be avoided? Chris Kitchenham, director at stockbroker and investment manager Walker Crips, argues that it isn't an evil in and of itself, but rather another moving part that can benefit or damage your investment.

Kitchenham says it isn't easy to hedge against currency risk and that doing so could even weaken your portfolio. 'When you diversify, if you hedge against currency risk, you give up half your diversification,' he says.

Keep in mind too that over the long term currency volatility tends to even out. Volatility can be further tempered by diversifying across currencies, so while one might be falling another could be on the rise.

Geopolitical risk is a tricky problem. However, Jeremy Le Sueur of 4 Shires Asset Management says that by thinking carefully about and paying close attention to economic conditions in foreign countries, you can avoid some of the big pitfalls.

When looking to invest in another country, Le Sueur points out that if you want to pick specific countries, you will have to do your own legwork, evaluating factors such as import/export balances, government defaults, GDP growth projections, population demographics and inflation rate.

'Each economy will have different characteristics because of those factors,' says Le Sueur. 'Those are good yardsticks.'

If that sounds like a lot of work, don't despair. A well-diversified global trust will do that research for you and actively adjust weightings between regions and countries.

BENEFITS OF INVESTMENT TRUSTS

Liquidity is one area where closed-ended trusts can confer real benefits over open-ended funds. This is because the manager of the trust doesn't have to buy assets - possibly at elevated prices - as money flows in, or sell assets into a falling market to fund an unexpected outflow. Instead, the share price simply absorbs changes in cash flows.

Finally, we come to the income question. One of the big appeals of the UK is its established dividend culture. But according to Mike Kerley, manager of the Henderson Far East Income trust, income investors in the UK tend to rely too much on income from a select few companies and sectors such as financials, mining and energy.

To put that into context, if we look at the top 10 holdings in the five largest trusts in the Association of Investment Companies' UK equity income sector, we see that 14 companies appear among the biggest holdings in at least two of the five trusts and four companies appear in three. One - BP - is a top-10 holding in four out of the top five.

However, this does not mean the UK equity income sector must be a better option than the global equivalent. In the UK companies tend to pay out about half of their profits in dividends, while in Asia, for instance, that figure is more like 30 per cent.

Although this may detract from Asia's appeal for income investors, Kerley argues that it indicates potential for dividend growth that might quickly become very appealing if high inflation returns in the UK.

'What we should be investing for is growth, not yield differentials,' he says, 'and investment for growth hasn't happened in five years.'

An international skew will be more appropriate for some investors than others. For example, an investor's age shouldn't necessarily dictate the balance they strike between UK and global assets.

However, typically, investors often prefer to take less risk as they get older. The fact that currency risk is a shorter-term danger when investing internationally might be a reason for older investors to bring some assets home.

So where to turn? Some generalist global trusts with a healthy slug of UK exposure could form the backbone of an international trust portfolio - Henderson Global is one example.

If you prefer the focused expertise of specialist managers, you can build your own portfolio out of several more-specific regional trusts. Money Observer's Rated Funds provide a good starting point (see table above, click to enlarge).


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