Why it pays to diversify - Y TREE Why it pays to diversify - Y TREE

Betting on Britain

UK asset managers allocated 23% of all investments to UK equities in 2021, according to The Investment Association Annual Survey. Given the UK market represents just under 4% of the global market, that’s the equivalent of taking a 6x bet that UK markets will outperform.

This approach has its downsides.

Performance of £100 invested in the UK 
vs the world (2013 to 2023)
Source: Refinitiv Datastream, MSCI. Total return index and net return index from 30/08/2013 to 31/08/2023

We analysed the performance of the UK equity market in comparison to the developed world over the past decade. As shown above, a UK investor placing their capital in the FTSE All-Share would have seen their portfolio grow by 5.4% per year on average. In comparison, global developed markets returned almost 9.3% per year on average – over two thirds more than the UK.

There’s no place like home

Asset managers have a soft spot for their own country when it comes to investing. Their wealth of expertise lies predominantly in UK companies and so they tend to stick to what they know. Managers feel more at ease investing in companies and industries they recognise, assuming that’s a safer choice than venturing into foreign territories. 

In addition, investing in their local market avoids any complications and additional risks that may come from purchasing and selling investments in a foreign currency. In order to mitigate these risks, UK asset managers can enter into derivative contracts that aim to eliminate the foreign currency risk to the British Pound, however, doing so can be complex and costly, so it is often ignored. 

While it is possible to invest globally without entering into derivative contracts, it leaves investors exposed to unrewarded currency risk.

Why it pays to diversify

Diversification can enhance your returns and reduce your exposure to the specific risk associated with a particular geography, company or industry. Conceptually, this is simple to understand – putting all your eggs in one basket leaves you exposed to losing all your eggs. Of course, in periods where single markets outperform, you could miss out on returns. The question is whether you are willing to risk all your eggs.

Take the following findings of the report from Cliff Asness, Antti Ilmanen and Dan Villalon from AQR1. The analysis looks at individual downturns for 22 different countries since 1950 and compares returns to a global portfolio2.

1 Asness, C, Ilmanen, A, Villalon, D 2023, International Diversification—Still Not Crazy after All These Years, The Journal of Portfolio Management. Graph has been adapted from the original.
2 The global portfolio represents the portfolio held by an investor who chooses to diversify globally. It represents an equal-weighted portfolio of all stock market indices and does not hedge foreign currency exposure. Given the differences in currency returns and inflation, the global portfolio represents an average of 22 separate global portfolios, 1 from each of the 22 countries’ perspectives.

Global vs local: Why it pays to diversify
Source: AQR, Bloomberg, CANSIM, Global Financial Data, Datastream.
  • The pink line shows the cross-sectional average worst return each independent country suffered, starting from the moment of the downfall, in real terms, adjusted for local inflation. The downside is on average up to 60%.
  • The blue line shows the cross-sectional average return for the global portfolio when each country was suffering its worst event. For the same period, the global portfolio experienced an average downside of up to 40%, and even fully recovered that loss after 6.5 years.

It’s clear that holding a diversified global portfolio during periods of local downside volatility leads to better outcomes. While it does not totally protect the portfolio from negative local return events, over a long horizon, holding a global portfolio has a good track record of providing diversification when it is needed the most.

Over the past 20 years, diversifying investments away from your local market smoothes extremes and leads to more stable investment outcomes. Although these may not sound exciting, they mean that you can more reliably plan for the future and support changes in lifestyle, health, family, business, economies and markets.

Y TREE’s institutional approach

At Y TREE, we build long-term, diversified portfolios to support you regardless of market volatility. That means we focus on making sure you are diversified across public market risks – not just by asset class, but also by country, sector, company and risk factors. 

Rather than making bets on winners and losers, we help our clients understand what level of bad performance they can stomach financially and we ascertain whether that fits within their emotional tolerance. We then set a risk level that means they are always invested within their comfort zone, even in the worst market conditions.