Less of the UK, pleasePosted: 2016-01-06
Why you should strongly resist changing your asset allocation
The principles of successful investing are, so I gather from my extensive reading, pretty simple. Pick your asset allocation, making due allowance for your risk tolerance. Invest passively in it, optimise for tax and minimise fees, rebalance regularly – annually is often enough. Job done. Resist the temptation to tweak your allocation, trade within it or even look at your portfolio valuation .
Of course I’m not the only blogger who knows the principles yet ignores them in certain practices. But I certainly respect the principle of sticking to your asset allocation. One of the benefits of having a consistent allocation and rebalancing against it is that this enforces a ‘buy low sell high’ behaviour. Taking fright at, for instance, the Australian market underperformance and lowering your target exposure to the Australian market is exactly the wrong thing to do.
So, please believe me when I say that I take changes to my asset allocation very seriously. But nonetheless I am making one – quite a big one – and I’d be interested to have my thinking challenged.
Why I am going to change my asset allocation anyway
The trigger for updating my allocation is that I am about to take out a significant loan backed by my investment portfolio. This loan is to allow me to bridge a property purchase while minimising the amount of my investment portfolio that I need to sell. In theory, because my returns on this portfolio are, after tax, generally at least three times the cost of the loan, this strategy makes sense. But it is risky, because my returns will be leveraged by this loan. The loan is going to be about one third the size of my investments, which means that a 2% change in the value of the investments will make a 3% impact on my net equity value. Relative to typical housing leverage, this is tiny, but house price volatility is a lot lower than stock market volatility. This leverage increases my risk and I want to alter my asset allocation to reduce my levels of risk, in mitigation.
What allocation reduces the risk in my investment portfolio?
The obvious answer to reduce risk is to tilt the portfolio more to cash and bonds and less towards equity. I don’t believe in cash as an investment asset, which leaves bonds. Bonds however feel more risky than usual at the moment, with an enormous bull run behind them, and interest rates just starting an upwards march for the first time in 9 years. Nonetheless, the chances of bonds falling by 20% or more are much lower, to my mind, than the chances of the equity markets falling this much, so bonds are lower risk. And in fact A Wealth of Common Sense tells me that a (US) 60:40 portfolio has never suffered an annual loss of more than -14%; I could cope with worse than this and not fall out of my leveraged bed.
But as I’ve been reflecting on my risks over the festive break I think I need to radically prune the UK equity exposure in my portfolio.
Why the UK is too risky for me in 2016
Three things are driving this conclusion:
- The UK’s share of the world market. I’ve finally read Tim Hale’s excellent book – Smarter Investing – who lays this argument out very effectively. The UK is about 5% of global GBP and 10% of the global stock market. Even allowing for home bias – which I proudly sport – my current allocation of 55% to the UK feels far too high.
- The concentration within FTSE-100. The top 100 FTSE companies, FTSE-100, are over 80% of the UK stock market. And FTSE-100 is disproportionately skewed towards three sectors – commodities, financial services and pharmaceuticals – and away from technology. This skew almost singlehandedly explains FTSE’s fall in 2015, with commodity stalwarts like BHP, Anglo American, BP, Glencore and Shell losing 30-70% of their value, and there being no FANG (Facebook, Amazon, Netflix, Google) companies to make up the difference (pace Betfair, up 150% in 2015). I am aware that this argument is akin to selling something because it has fallen but I still feel the argument is a real one.
- Brexit and pension risks. The UK faces the prospect of at least one (and perhaps two) existential referendum later this year. This event creates enormous uncertainty, and markets dislike uncertainty. This could hurt equity valuations, business confidence, the pound, or some cocktail of all three. On top of this there is the prospect of one of the largest reforms to pensions ever, which bodes badly for the asset management sector in FTSE (such as Legal & General, Standard Life, Aberdeen, Prudential, etc). Potentially these risks are priced in, but volatility is likely either way.
What are my alternatives to my UK equity exposure?
Second only to my UK home bias is my bias for the US market. The US is about 25% of global GDP and around half of the developed market equity markets (see Tim Hale’s pie charts below). Its equity market, has a strong fiduciary / governance framework and I have a lot of experience of investing in it. In contrast the European markets are fragmented, frequently poorly governed, and inconsistently taxed, so they make me nervous. Australia aside, I have been barely interested in Asia at all since I learnt that stock market growth doesn’t correlate with GDP growth at all.
The next point to cover is the bond allocation. I am quite taken with Tim Hale’s argument that to the extent that bonds are to provide safety, they should (for UK investors) be UK government bonds. To me this isn’t the whole story – bonds are also uncorrelated assets – but it does justify a home bias for fixed income.
The final point to discuss is foreign exchange risk. Tim Hale argues (with data, shown below) that in general this risk balances out – sometimes you win, sometimes you lose. Certainly I am pretty comfortable taking UK/US forex risk. The Euro is harder to call and I wouldn’t go near any Asian / minority currency pairs. So overall I am going to treat GBP and USD as interchangeable, and see how I go.
My proposed new allocation
Having put a cold towel around my head I’m planning to move my allocation as follows.
The logic here is as follows:
- My Equity:Fixed Income:Cash mix is 2:1:-1. I.e. for £2m of equities, I’d have £1m of fixed income, and I’d take out £1m of margin loan, leaving me with £3m of gross investments and £2m of net exposure. This is a loan-to-value of 33%, which I feel comfortable with. And it is an equity:bond split of 66:34 which is considerably more conservative than my current 84:16.
- Australia remains at around 5%, which is roughly the amount of my life I spend there. I struggle to find good investable assets (except for commodity businesses, which are a brave call right now) in Australia, or else I’d have this a smidge higher.
- The UK and US are 75% of the investment total. This is home and US bias. But this percentage is closer to the share of global stock markets than it looks. 75% across both is only a bit lower than the 80% I had before. This leaves ‘International’ as the balance – 20% – which is slightly higher than the amount of my life I spend there but not by much. The vast majority of International to me is in the Eurozone.
- Within UK/US, the UK is slightly bigger. I’ve been minded to increase the US above the UK. But right now the UK is 55% of the net total for me, compared to the US at 25%, and I don’t want to throw the whole UK baby out with the allocation bathwater. Plus I think my UK bond holding should be bigger than my US bond holding. But this rebalance is getting the US close to 1:1 with the UK.
- My margin loan will be 50:50 GBP:USD. This means I’ll be borrowing in USD to help fund my UK house. This sound crazy, but I see it as diversifying my GBP risk. And it reflects the fact that margin terms are better for US investments.
(Note – I’ve had feedback that this table, with negative cash percentages, is confusing. I’m glad I’m not the only one finding this confusing – don’t try this at home! But to try to make this clearer….
Consider a scenario before leverage: I have a £1000k portfolio, with £666k equities, £333k fixed income, with no cash. This has Equity: 66, Fixed Income: 33, Cash: 0.
Now consider that I borrow £333k from a bank, secured on this portfolio, which I then spend on a folly – so the £333k disappears. My gross position remains £1m, but my net position is now £666k. My portfolio now has a negative cash balance of £333k, but still has £666k equities, and £333k fixed income. At this point the cash balance is -50% of the net position (the inverse of the fixed income position, by co-incidence); the equities at £666k is 100% of the net position, and the fixed income at £333k is 50% of the net position. This is the situation my table above describes.)
Right, that’s it. This is a big change – it will mean more than tripling my relative fixed income exposure, and quadrupling my US fixed income exposure, at the expense of my UK equity positions.
What do people think? Too complicated? Too mad? Too risky? What would you be worried about if you were in my position?