The rise of asset allocation
Tuesday 31st January 2017
Written by Janette Rutterford
Since the Brexit referendum and Donald Trump’s election as President of the United States, investors have woken up to the fact that it makes sense to reduce risk by investing in a range of overseas markets in a number of different currencies.
This is particularly true in the UK, where the FTSE100 index has done reasonably well post-Brexit as most of the top 100 earn revenues in foreign currencies, whilst the more domestically oriented FT All Share index has done much worse.
Exchange Traded Funds (ETFs) now allow investors to create a global investment portfolio at relatively low cost. Just a few clicks and you can be tracking the S&P500, the Nikkei index, or an index representing non-UK European stock markets.
The dilemma the investor now faces is how much to put in each country. In other words, what asset allocation strategy to pursue? How much to put in the domestic market, how much overseas?
Traditionally, investors preferred to put most of their money in their home stock market. Their brokers recommended shares listed on the local stock exchange (and there were provincial stock exchanges until the 1960s).
They felt more comfortable buying shares in companies whose buildings they could see, like J. Lyons tea rooms, or whose products were advertised, like Liptons tea. But there is no such thing as a home market now.
Famous British names, such as the Mini, are owned by foreign companies. Buying UK shares is effectively buying a set of international securities with varying amounts of exposure to different countries and currencies.
So the 64 trillion dollar question is: how much to put in each country? There are essentially three different ways to decide.
One is the Capital Asset Pricing Model (CAPM) approach, which says to buy what’s available. For example, North American stock markets account for 41% of global markets by value, Asian markets 33.3% and Europe 19.5% (including 4.7% for the London Stock Exchange). You can amend these numbers to make allowances for double counting or illiquidity, but the implication is clear. Put most of your money in the US, Europe and Asia, including less than 5% in the UK. There’s no local bias in this approach.
The second approach is what is called naïve diversification, which was the approach recommended for global portfolios pre-World War I, the first era of globalisation. This involves dividing the world into say ten different regions and putting an equal amount in each. In those days, there was no currency risk; you could buy sterling-denominated securities relating to countries around the world.
Today, that’s no longer the case. And this strategy could mean putting 10% into each of Africa, Australasia and South America compared with their combined importance in world markets of less than 5%. And it definitely means putting no more than 10% in the UK. An even more challenging strategy?
The third, most popular way is to adopt a Portfolio Theory approach, but tinker with it. Portfolio Theory is a model which inputs historic returns, volatilities and correlations between markets, and comes out with the percentages to invest in each to get a good expected return for a minimum of risk.
This is the approach which many of the robo investor sites are offering. Tell them your risk and return expectations and they’ll come up with an asset allocation strategy. This will have what appear to be random percentages in different markets, neither related to size nor evenly spread. Although you can’t see it, these are the outputs from the PT model based on the risk and return characteristics of each market. What you don’t know is how much the outputs have been tweaked to pander to local bias. You can guess that they have tweaked if the UK percentage is higher than 5 or 10%.
There is no perfect solution. But at least we know one thing. No longer are we expected to put most of our money into UK securities or funds. Now, we are expected to argue the other way.
Why should I invest more than 5 or 10% of my portfolio into the UK? Global asset allocation has come to stay.
*Janette Rutterford is a Professor of Personal Finance Capability at the Open University
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