It pays to think global – but diversification is no free lunch
WE ALL know the logic – don’t put all your eggs in one basket, because diversification is the key to success. But so many investors still fall at this hurdle when it comes to investing globally.
The first point to remember is that, when you’re invested in just one market or group of territories, you’re not only at risk from market volatility, but the risk of any political instability or local policy decisions could also impact your returns.
This applies not only to higher-risk emerging markets, but also to developed markets. We saw a high level of political uncertainty in the UK this year with the Scottish independence vote in September, and it seems that this will continue into next year with the May general election. Of the 23 developed equity markets, the UK’s FTSE All-Share index has ranked nineteenth for performance this year – only ahead of Norway, Austria and Portugal’s markets.
Second, not all markets are created equal, so your portfolio can end up with a bias to a particular sector or investment style. Companies can, of course, choose where they list, depending on the market they feel best supports their industry and business model. The US tends to attract tech companies – the recent IPO of Alibaba, for example, was in the US rather than China. Compared to global markets, the UK is biased towards financial companies and commodity exposure, but is light on technology and consumer companies.
As well as looking overseas for better returns, diversifying globally can reduce risk. A portfolio containing 70 per cent UK equities and 30 per cent global equities would have not only outperformed a UK-only portfolio over the last 30 years, but done so with less risk. And many more asset classes that can be used to diversify a portfolio are becoming more accessible to private investors – like emerging market bonds.
But investing globally is not a free lunch – one of the downsides is having to accept currency risk. It’s notoriously difficult to predict currency movements, and it has the potential to significantly boost or cut your returns. This year, a weaker sterling has boosted returns, but in 2013 the reverse was true.
One common misconception is that, if an investment fund is traded or priced in sterling, this means it has no currency risk. In fact, most investment funds are fully exposed to currency movements. In some instances, investors can buy “currency-hedged” funds to eliminate forex risk. A good case is Japan, where we would always invest in a currency-hedged fund, as a weaker yen is normally a pre-requisite for Japanese market outperformance. So far this year, a sterling-hedged exchange-traded fund investing in Japan would have produced a return 8 per cent higher than one that wasn’t hedged.
There is, of course, a fine balance to be struck between investing in UK and global markets. Too much global exposure will put the stable growth of your investments at risk. But done well, global diversification can improve the effectiveness of a portfolio. However, my key piece of advice would be to understand your level of currency risk, and how this is handled in each of the funds you’re invested in.
Shaun Port is chief investment officer at Nutmeg. www.nutmeg.com