Excessive allocations to UK stocks may limit risk‑adjusted returns.
- Many UK investors display home bias in their equity allocations as overseas markets are often perceived as riskier and more difficult to access.
- Too much home bias will likely result in heavy exposure to sterling and an overweight to “old economy” value stocks over “new economy” growth stocks.
- UK investors who allocate more to overseas markets may achieve better risk‑adjusted returns.
Home bias in equity portfolios is common in the UK, as it is in other countries. According to industry research,1 UK institutional investors recently held almost 30% of their equities in UK companies; among retail investors, the figure was more than 45%. To put this in context, the weight of the UK stock market in the MSCI All Country World Index (ACWI) is about 4%.2
It is easy to understand why many UK investors display home bias. Overseas markets are often perceived as riskier and more difficult to access than the UK market, requiring greater levels of research and expertise. By comparison, the London Stock Exchange, with its long‑established reputation as one of the world’s leading financial centres, is seen by many an easier, cheaper, and safer place to do business.
However, foreign equity markets are becoming more accessible, and the risks associated with investing in them have diminished as currency hedging has become more widely practiced. What’s more, globalisation has meant that UK investors are just as familiar with foreign names like Samsung and Apple as they are with Tesco or Barclays. As overseas markets open up, UK investors with too much home bias may be missing the opportunity to diversify their portfolios and boost risk‑adjusted returns.
The Impact of Home Bias on Portfolios
Because the UK stock market includes a large number of stocks and is well diversified, UK home bias is not as risky in terms of concentration risk and volatility in comparison with other countries with narrower local stock markets. However, according to our analysis, over the past 30 years, stronger UK home bias would have resulted in lower risk‑adjusted returns as measured by the Sharpe ratio of a global equity portfolio (Figure 1).
This is partially because of the underperformance of the FTSE 100 relative to ACWI excluding the UK and partially because of the depreciation of the British pound sterling, boosting foreign stock investments denominated in other currencies.
Too Much Home Bias Hinders Returns
(Fig. 1) Hypothetical risk-adjusted return of equity portfolios with different levels of UK home bias
Past performance is not a reliable indicator of future performance.
As of 31 May 2020.
MSCI All Country World Index (ACWI), MSCI ACWI excluding UK, FTSE 100. X% UK represents X% allocation to the FTSE 100 and (1-X)% allocation to MSCI ACWI excluding UK. Calculations based on monthly index total returns measured in GBP over the period January 1990 through May 2020.
Sources: MSCI and FTSE/Russell (see Additional Disclosures); analysis by T. Rowe Price.
The FTSE 100 and Sterling: An Inverse Relationship?
Although the FTSE 100 used to be the bellwether of the UK economy, international corporations have largely replaced the UK‑focused businesses and conglomerates in the index, reflecting the globalisation of the UK, its greater focus on overseas markets, and takeover and merger activity. From an index that reflected the fortunes of the UK economy in 1984, the FTSE 100 has evolved to reflect the fortunes of the global economy in 2020.
The increasingly global focus of the largest UK‑listed companies has meant that their share prices can be driven to a large extent by moves in sterling. While stocks incorporated and traded in the UK are denominated in British pounds sterling, the export‑oriented nature of the FTSE 100 companies has meant that the index has tended to have an inverse relationship with the currency in recent years. When the pound appreciates, exports of British companies with overseas sales suffer because what they sell becomes less competitive, and vice versa. The FTSE 250, representing the next 250 largest listed UK firms, is more appropriate for investors whose base currency is the pound and who would prefer that currency moves have less impact on the value of their investments.
In periods of high uncertainty for sterling, currency movements can have a major impact on how the FTSE 100 fares relative to the FTSE 250. For example, following the UK’s referendum decision to leave the European Union in June 2016, the resulting fall in sterling was a major factor in the FTSE 100’s relative outperformance against the FTSE 250 over the remainder of 2016—the FTSE 100 was up 15% by the end of the year, while the FTSE 250 only saw a 6% rise over the same period.3
An Inverse Relationship
(Fig. 2) The British pound sterling and the FTSE 100
As of 31 May 2020.
FTSE 100 monthly total returns measured in the GBP and the GBP/USD exchange rate over the period January1990 through May 2020.
Sources: MSCI and FTSE/Russell (see Additional Disclosures); analysis by T. Rowe Price.
The Sectors of the FTSE 100: Old vs. New Economy
Investing in UK stocks also means taking a view on certain sectors. Compared with the S&P 500 and the MSCI ACWI indexes, the FTSE 100 overweights the four sectors most associated with value—financials, utilities, consumer staples, and energy—and underweights the two sectors most associated with growth—information technology and consumer discretionary. Investing in the UK stock market is therefore to take a view that “old economy” sectors are likely to outperform “new economy” sectors and that value stocks are likely to outperform growth stocks—indeed, this has been a major reason for the underperformance of the UK market versus global equities in recent years.
Bias Toward Value Over Growth Has Led to Underperformance
(Fig. 3) Sector weights of the FTSE 100, S&P 500, and ACWI
As of 19 June 2020.
Sector weights of FTSE 100, S&P 500, and MSCI All Country World Index (ACWI) as of 19 June 2020. Sources: FTSE Russell, S&P, and MSCI (see Additional Disclosures); analysis by T. Rowe Price.
Looking to the Future: Yield Scarcity and Dividend Yield
The UK faces major secular global geopolitical changes. These include Brexit, U.S.-China trade tensions, the future of the European Union, and the changing post‑coronavirus world. While change means risks, it also means opportunities. During turbulent times, prices may fall, making valuations attractive, and when certainty returns, depressed prices may climb. Coming out at the other side of the uncertainty of Brexit and COVID‑19 (the disease caused by the coronavirus), the UK may be attractive for investments.
We expect the UK stock market to perform relatively well compared with other stock markets over the next five years. The five-year annualised expected return for UK equity is 7.7%, compared with 5.7% for global equity, 4.7% for U.S. equity, and 6.7% for emerging market equity.4
However, completing Brexit is likely to impair UK economic growth as domestic firms face costs of doing business with their largest trading partners in Europe, pushing up wages and inflation. In this environment, the British pound sterling is likely to strengthen marginally but remain relatively weak. Because the UK equity market is so internationally focused, a weak currency will help to lift earnings and boost the dividend yield. The UK equity market also benefits from a relatively attractive valuation following years of underperforming other equity markets (Figure 4) and high dividend yield compared with other equity markets, an advantage in an environment of low yields.
The UK Market Is Currently Undervalued
(Fig. 4) Valuation of equity markets as of June 2020 relative to history
As of 30 June 2020.
Indices used: FTSE 100, FTSE 250, FTSE All-Share, ACWI, S&P 500, MSCI Europe excluding UK, MSCI Japan, and MSCI Emerging Markets. Percentile of valuation metric as of 31 May 2020 compared with past levels over the last 15 years. Valuation metric is an average of 1-year forward-looking P/E (price to earnings), P/B (price to book), and P/CF (price to cash flows).
Sources: FTSE Russell, S&P, and MSCI (see Additional Disclosures); analysis by T. Rowe Price.
Casting a Wider Net
The size and breadth of the UK equity market means UK stocks have a place in global equity portfolios and not only those of British investors. While some UK home bias is understandable and should not materially impact long‑term results, an extreme home bias might cause a global equity portfolio to become suboptimal. Reducing exposure to the UK market does not mean that all holdings need to be global in nature. Exposure to UK companies can continue to be obtained through strategies investing in the UK stock market, or through European or global strategies that can select the best UK stocks. Additionally, investors who are looking to obtain more targeted exposure to the UK economy via an equity investment may find it worthwhile to consider a portfolio benchmarked to the domestically focused FTSE 250, rather than to the global behemoths of the FTSE 100.
Given the current attractive valuations of the UK stock market and weak British pound sterling, any change to UK home bias should be implemented gradually. This will help investors to avoid selling stocks and sterling at depressed prices and, instead, would average out the prices of selling and buying rather than betting on a price at a single point in time. This pound cost average is an approach we look to adopt, especially when making larger strategic changes to investor portfolios.
1 Pension Protection Fund. 2019. “The Purple Book 2019.” Simple average UK equity exposure of UK defined benefit schemes.
2 MSCI (see Additional Disclosures) as of 31 May 2020.
3 Source: FTSE Russell (see Additional Disclosures); analysis by T. Rowe Price. Total return from 24 June 2016 through 31 December 2016.
4 Source: T. Rowe Price. 2020. “Capital Market Assumptions: Five-Year Perspective 2020.” Annualised forecast in British pounds sterling.
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