Investors driving outflows from UK equity funds may be missing a key point.
Namely that UK equities’ declining correlation with global equities is making them a powerful diversifier.
Granted, US and world equities have persistently outperformed the UK equity market from a returns perspective. But from a diversification perspective, UK equities have a useful role to play.
Getting proper diversification
For asset allocators looking to build-in diversification by having different global or US equity funds from different providers, this provides little no diversification from a risk perspective as they are so highly correlated.
Correlated funds will move broadly in tandem, regardless of which active manager or style it is, and regardless as to whether its active or passively managed.
But pairing a global or US equity fund with a UK equity fund introduces true (risk-based) diversification within the equity portion of a portfolio because of the UK’s low correlation and very different and sometimes opposite return pattern.
Recall 2022, the inflation shock from the Russia/Ukraine war and related sanctions meant that the UK equity market was up, when the US and hence world equities were down.
Similarly, this year the UK equity market has frequently moved inversely to the US and world equities in January, April, June and July. It has actually been a source of portfolio resilience.
The power of correlation
By combining lower correlated assets, the risk of the portfolio whole can be less than the sum of parts.
Looking at long-run 10 year historic data as at end 2023, the US and UK correlation to world equities is 0.97 and 0.80 respectively.
But looking at short-run one year data to end July, the US is still 0.97, but the UK is far lower at 0.61.
Short-run UK equity correlation with world equities has visibly decoupled from world equities. Prior to 2015 UK and US equities were similarly correlated to world equities over the short-run.
We then see two clear periods of material disconnect. One following Brexit and the second following Covid and subsequent related inflation shock and the marked by divergence between tech-oriented US market and value-oriented UK market.
How much to have in UK equities?
UK discretionary managers of a typical “balanced” portfolio have shifted from having 70 per cent of the equity allocation in UK equities back in 2000 to just 33 per cent in UK equities today, according to our research.
Global equity indices are less generous. The UK equity market’s index weight has shrunk from approximately 10 per cent as recently as 2011 to approximately 4 per cent today.
The shrinkage is a function of simple maths. A far greater number of the rest of the world’s listed companies (predominantly the US) have grown their earnings (and hence market capitalisation) far more than the UK’s listed companies. As a result, the UK’s relative size has shrunk.
Twenty’s plenty
In our work with UK financial advisers and wealth managers, we found a range of opinions. We have always considered a UK equity allocation of 30-50 per cent to be too high, even though that was often the existing default for firms using either third party asset allocation models or asset allocation benchmarks overseen by the UK’s largest wealth managers.
