The Brexit referendum was over a year ago now, Article 50 has been triggered and negotiations on the UK’s terms of withdrawal from the EU started. Theresa May called a snap general election in full confidence a Labour party in disarray and led by media figure of scorn Jeremy Corbyn would be easy pickings, giving a boost to the Conservative parliamentary majority. Labour, while they eventually lost the election, took the fight to May, Corbyn leading the charge, and wiped out the Conservatives’ majority, forcing them into a coalition with Northern Ireland’s DUP, the hardline Unionist party founded by the Rev. Ian Paisley.
May’s authority both within her own party and in the eyes of the EU’s negotiators has been severely tarnished, possibly fatally. Negotiations with the EU have not started smoothly and whether a Brexit deal that can be considered balanced to both sides and manages to make the best of the situation is likely has to be in doubt.
Whether you are pro or anti-Brexit, that’s a brief summary of the current situation we find ourselves in. It’s a massive change in our political landscape but ultimately the chances are that the UK will be ok, life will go on and we’ll settle in to a new ‘normal’. Some believe that when the dust settles we will come out of the other end better off, freed from the shackles of negotiating trade deals as part of the EU block and all of the red tape and complex regulation that involves. Others are convinced that Brexit will result in an acceleration of the UK’s trend of steadily decreasing relevance as a global economic and political power. There is a not entirely unfounded fear that the EU will attempt to make an example of the UK, even if to their mutual detriment. We could be frozen out as a deterrent to any other member who might be experiencing wobbling loyalty to the collective.
Basically, from where we currently stand, almost anything could happen. The chances are that sense will prevail and some kind of deal will be struck before we are due to fully exit the EU sometime in 2019. Whatever the eventual outcome, and no one can say with any certainty what that will be, it will be another decade before we really know if things have worked out positively or negatively for the UK’s economy. The same can be said for that of the EU. In the meanwhile, the only certainty is that there will be a period of uncertainty both for the UK and EU economies.
Uncertainty No Friend to Investment
Another certainty, or as close to a certainty as possible when it comes to financial markets and economies, is that they do not take kindly to uncertainty. Other than a significant drop in the value of the pound, which actually boosted the FTSE 100, the UK’s economy has proven itself to be far more resilient than expected over the year and a bit since the original referendum result. Despite the lack of clarity over the future of the UK’s economic relationship with the EU and other global partners, which usually stifles investment, things have ticked along better than expected thus far.
However, while there is plenty of debate as to how negatively the UK economy will be hit by the uncertainty and turmoil that is inherently part of our EU exit, no one really disputes that there will be negative impact on growth, at least in the short term. Such a momentous political shift and the degree of uncertainty it leads to make that unavoidable. Until there is clarity on the big questions such as trade deals and immigration rules it is inevitable that investment will be stifled.
The Principle of Risk Premium and is the Only Way Down?
One of the most solid principles for investing is that uncertainty has a negative impact on price. A piece of research by investment managers Legal & General posits that a x2 jump in political and economic uncertainty can knock 0.5% off a country or region’s economic growth. The same piece of research forecasts that the UK might be sliding into recession based on an uncertainty reading of x6 in the wake of Brexit. And things don’t look great for the EU either, with an uncertainty reading of over x3 the average. *Source: http://www.policyuncertainty.com/
It seems inevitable that Brexit will stimmy growth in both the UK and EU over the coming few years. With so many variables for both sides in the final outcome of negotiations, there will be a risk premium on investment decisions.
Another factor to consider is that while the pound has dropped against other major international currencies in the past year, financial and property markets are near record highs. While it’s not impossible that the stock market and property prices keep rising, particularly within the present context the more likely scenario would be that at some point, and in the not too distant future, we will experience a correction.
There is already mounting evidence that growth is stalling in a giddily-high property market, particularly in London and the South-East. The stock market is still doing well, propelled to current heights by loose monetary policy over the past several years by major central banks around the world, but most experts fear a pending correction.
The real debate more surrounds when exactly that might happen and how severe it will be than if it will happen. Valuations are currently at the high end of traditional ranges and quickening inflation spurred by the drop in the pound could well lead to the Bank of England instigating an interest rate hike later this year or early next. Both factors do not bode well for equity markets in the medium term at least. European equities indices such as Germany’s DAX have also very recently hit record heights.
All in all, it’s hard to imagine a scenario where UK-focused investments, and quite probably also EU-focused peers, won’t take a hit of some kind in the next couple of years. This brings us to another central maxim of smart investing: buy low and sell high.
Is now the perfect time to rebalance an investment portfolio by taking profits out of UK and EU-focused assets while the going is still good and before what seems like an inevitable downturn takes hold? Well, we can’t say that for sure, no-one can. However, the arguments outlined so far do suggest that the risk to reward ratio for UK and EU-focused assets is currently at its most unfavourable point in a long time.
Diversity Requirement of a Strong Investment Portfolio
Leaving aside for now present economic and political uncertainty in the UK and EU, historical data clearly demonstrates that over the long term well-diversified investment portfolios perform considerably better than those with a narrower focus. Diversification takes two main directions: between asset classes and geographical exposure.
Exposure is how much an investment could fall in value due to risks specific to the individual asset, market sector, its wider class eg. equities, and geographical focus. Diversification is a risk management technique that smooths out risk events so that the negative performance of part of a portfolio is neutralised, or at least minimized, by the positive performance of the remainder.
Numerous studies focused on different international markets, from the U.S., to the UK, Europe and Asia have clearly demonstrated that for rolling 3-year periods over 10 to 20 years, well-diversified investment portfolios outperform less diversified alternatives. These studies almost universally (over 90%) demonstrate better performance for well-diversified portfolios over these three year periods, and usually by over 2% annualised.
Why Diversify Between Asset Classes
To achieve the best risk to reward ratio from an investment portfolio it is important to not only diversify well within an asset class but also between asset classes. The equities section of a portfolio should, to what degree depends upon factors such as the overall value of the portfolio, contain a good mix of different shares. This means not having any significant % tied up in shares of any one company but also mixing income, value and growth equities. We’ll look at international exposure more closely in the next section but it is also important to diversify geographical risk.
However, while equities from different geographies move in cycles and the top performers change from month to month and year to year, there is also a degree of correlation. Major market crashes tend to have international influence. Diversifying between as well as within asset classes adds an additional layer of risk protection to a portfolio. This is especially the case when the mix includes asset classes which are not closely correlated.
Diversification between asset classes is more about reducing volatility than maximising gains. A recent study by Fidelity Investments looked at the difference between all-equity and asset class-diversified portfolios during the 2008/09 international financial crash and the several subsequent years.
The diversified portfolio still showed losses during the crash, little didn’t, but they were smaller than those of the all-equity portfolio. While the all-equity portfolio subsequently showed stronger gains as the market recovered in subsequent years, the diversified portfolio also performed well. An asset class-diversified portfolio does not maximise gains when markets are moving up but it will secure most of those gains while providing lower volatility during downturns.
Asset Class Options
There are several choices when it comes to diversifying between different asset classes and we’ll briefly cover some of the most popular here.
Fixed Income Bonds: fixed income bonds pay an agreed return to a schedule over a defined period. At the end of that period the bond issuer redeems the bond’s original purchase price. While equities involve buying a stake in a company, bonds mean buying debt against interest. The holder has essentially made a loan to the issuer. Fixed income bonds come in a variety of different forms.
Government bonds, or gilts, tend to offer relatively low returns but are considered to have the lowest risk profile as the investor’s exposure is to the possibility of the country defaulting. While this has happened in the past it is rare. The higher the country’s credit rating the lower the theoretical risk of default and the lower the return paid by the bond issuer.
Corporate bonds carry a slightly higher default risk and so pay higher returns. Because the risk level is still relatively low and returns on corporate bonds can be quite high, potentially up to 7%-8%, they are a popular choice for diversifying a portfolio. In the same way an investor is best advised to split an equities holding between large, medium and small cap equities, and also between companies in those categories, ideally bond holdings should also be diversified.
Property: property is also a popular investment diversifier. It’s popularity stems from its income generation potential as well as perceived relative safety. As long as a property is producing a reasonable rental income, temporary losses of resale value can be ridden out as long as the owner is under no time pressure to sell. Of course, there is still a risk that a property holding could remain untenanted for a period of time.
Property investment is also split between residential and commercial property, each sector with its own strengths and weaknesses. As well as direct ownership of property investors can also diversify through other investment classes based on underlying property assets such as property-focused bonds, REITs and other forms of property funds such as mutual funds and ETFs.
Gold: as an asset class gold splits opinion. As a commodity, it is not income earning and investors can realise a profit only through selling holdings at a higher market price than at which they were purchased. However, it is often most appreciated as a store of value and safe haven in a diversified portfolio. During periods of market turbulence, particularly full-blown crashes, capital has historically piled into gold as a safe haven of value, pushing up its price. It is in this inverse correlation to financial markets that gold’s value lies.
Gold is typically held as part of a diversified investment portfolio either as a physical commodity or via ETFs.
Cash: while cash sees its purchasing power gradually eroded through inflation, most diversified portfolios retain at least some cash element to their make-up. Holding cash is a buffer against financial market downturns and crashes. Cash reserves mean other assets can be held until they, hopefully, regain value and don’t need to be sold at the market’s bottom to release cash flow. Cash can also help maximise gains when the market turns around by being used to purchase low cost assets during a dip or trough.
Why Diversify Internationally
As already touched upon, spreading international exposure in a portfolio is also a crucial aspect to achieving strong diversification. There are a number of reasons for this. The first is that it is rare for any single geographical market, either for equities or other asset classes such as bonds and property, to consistently be the strongest performer over any extended period of time.
Most benefit from international diversification comes from spreading assets between geographies with lower correlation between each other. For example, EU markets are generally highly correlated across asset classes and the UK and US equity markets have historically moved together in similar patterns.
Combining exposure to slightly less correlated mature markets, such as non-EU countries like Norway, Denmark and Switzerland or Australia, Canada and the U.S with exposure to emerging and developing markets would be expected to have a similar impact on reducing volatility as diversifying between asset classes.
It’s also possible to diversify international exposure through some forms of UK-based assets. For example, most FTSE 100 companies generate most, or a significant part of their revenues from international operations. This is one reason why the FTSE 100 soared after last year’s Brexit vote. With the pound losing value British exports became more price competitive and revenues generated in other currencies also added up to a higher value in pound sterling when added to the bottom line.
Currency risk is another important factor in international diversification. If the pound drops in value, holding assets denominated in other international currencies will help offset that for the same reason. Income earned in other currencies, or the sale price if assets are cashed in, add up to more pounds in a UK-based investor’s bank account.
Let’s take the simple example of a £100,000 property investment made outside of the UK. If the pound subsequently dropped by 5% against the value of the currency the property is denominated in, a 5% profit in pounds would be realised even if the property were resold for the original purchase price.
In recognition of this, many major UK wealth and investment managers have rebalanced fund weightings to greater international exposure in recent years.
Most have their opinion on how Brexit will eventually work out for the UK 5, 10 or 20 years from now. However, regardless of whether you are in the positive, negative or neutral outlook camp, arguably every major study ever conducted has demonstrated that over the medium to long term, well-diversified investment portfolios perform better. Even assuming Brexit had not taken place, diversifying between asset classes and international exposure has been demonstrated as the historically best performing approach to investment.
The currently heightened level of political and economic uncertainty for the UK and EU mean that risk levels are higher than normal. As such, the incentive to assess how well diversified an investment portfolio is and rebalance if necessary is also higher than at any point in the past decade.