Sources of diversification for UK-based investors

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Topic Author
danielbird193
Posts: 36
Joined: Thu Mar 21, 2019 2:15 pm

Sources of diversification for UK-based investors

Post by danielbird193 »

I've been following with interest discussions elsewhere on this site about how to diversify a simple index-tracking portfolio. Typically that involves people adding some international exposure, small-cap exposure or 'factor' exposure (e.g. value) which are thought to have lower correlations with global indices in the hope of improving the risk/return profile of their overall portfolio.

I'm in the UK, plan to work for 25 years or so until retirement, and my current target asset allocation is set as follows:

54% global equities (mostly in a low-cost MSCI World Index ETF, although I also invest in two well-known actively-managed investment trusts)
16% UK equities (a low-cost UK index trust)
20 % global bonds (Vanguard global bond index, hedged to GBP)
10% real estate (split between a low-cost global REIT ETF and an actively-managed UK commercial property investment trust)

I recognise that the allocation to real estate provides some diversification benefits, but I'm wondering if there's anything other asset classes I could look at to increase this further? Current thoughts are opening up a 10% holding in either: (1) a global small-cap ETF (although these tend to have a high correlation with the MSCI World Index); (2) a global "value" factor ETF, or (3) a short-duration high-yield bond fund.

Any thoughts on whether I would benefit from increased diversification and, if so, whether the asset classes listed are the right ones to be thinking about?
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Schlabba
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Joined: Sat May 11, 2019 9:14 am
Location: Netherlands

Re: Sources of diversification for UK-based investors

Post by Schlabba »

The MSCI world does not include emerging markets. So I would look at that one first.

To the question of whether or not you need more diversification; do you find yourself worrying about a downturn or the price swings?
Secretly a dividend investor. Feel free to ask why.
Valuethinker
Posts: 41129
Joined: Fri May 11, 2007 11:07 am

Re: Sources of diversification for UK-based investors

Post by Valuethinker »

danielbird193 wrote: Tue May 21, 2019 8:27 am I've been following with interest discussions elsewhere on this site about how to diversify a simple index-tracking portfolio. Typically that involves people adding some international exposure, small-cap exposure or 'factor' exposure (e.g. value) which are thought to have lower correlations with global indices in the hope of improving the risk/return profile of their overall portfolio.

I'm in the UK, plan to work for 25 years or so until retirement, and my current target asset allocation is set as follows:

54% global equities (mostly in a low-cost MSCI World Index ETF, although I also invest in two well-known actively-managed investment trusts)

16% UK equities (a low-cost UK index trust)
The UK stock market is highly globally diversified, thus there is no reason to under (or over) weight it against the global index.
20 % global bonds (Vanguard global bond index, hedged to GBP)
10% real estate (split between a low-cost global REIT ETF and an actively-managed UK commercial property investment trust)

I recognise that the allocation to real estate provides some diversification benefits,
I am somewhat sceptical of the diversification value of REITs - I think they track stock markets much more closely than they did. However at 10% it won't make a huge difference either plus or minus. It should give you greater inflation protection than ordinary stocks.

Just avoid paying capital gains tax. Also REITs tend to pay a higher dividend than the market as a whole, so beyond the £2000 pa exemption, that's not desirable. Unless you are holding in ISAs or pensions.

The choice of ISA and pension is critical. Assuming you are in a defined contribution or SIPP scheme then order of contributions is:

- pension first to the extent of the employer match
- full ISA allowance for self and spouse
(possible Children's ISA etc)
- remainder of annual pension allowance as long as your projections keep within the £1m (+ inflation) lifetime limit. George Osborne pulled the largest tax rise I have ever faced with that sleight of hand - nicely nailing those who had money in pensions, but not yet enough money to go for protection (i.e. over £1m)

If we change government then of course all bets are off - the investment world will probably change dramatically.
but I'm wondering if there's anything other asset classes I could look at to increase this further? Current thoughts are opening up a 10% holding in either: (1) a global small-cap ETF (although these tend to have a high correlation with the MSCI World Index); (2) a global "value" factor ETF, or (3) a short-duration high-yield bond fund.

Any thoughts on whether I would benefit from increased diversification and, if so, whether the asset classes listed are the right ones to be thinking about?
HY bond fund has a higher correlation with equities. Watch these things crumble in 2008-09.

I hold 25% of my Vanguard ISA in a global value factor ETF. I also hold the ishares one in another ISA. They are quite different - the Vanguard one clearly balances against the actual country weightings in the world index (so for example US is 66% v c 60% of the index) whereas the iShares one clearly just chases cheap stocks (so is 25%+ in Japan).

My view is that there's enough in the Value factor to have some "Lord make me chaste, but not yet" - St Augustine. However I am not betting the ranch on it. The gap between Value and Growth is the largest it has been since 2000 - on the other hand, Apple/ Microsoft/ Facebook/ Google (classic Large Cap Growth stocks) really are eating the rest of the corporate world as lunch and dinner (Amazon the valuation is forbidding c. 200x PE; Netflix is cash flow negative ).

Whatever you do, the only real diversification is into bonds from equities AND/ OR into inflation-linked bonds. The rest is basically marginal in terms of its impact, the correlations between equities, small cap, REITs, value stocks is just too great.

The suggestion to be market-weighted in EM is a good one.
Topic Author
danielbird193
Posts: 36
Joined: Thu Mar 21, 2019 2:15 pm

Re: Sources of diversification for UK-based investors

Post by danielbird193 »

Schlabba wrote: Tue May 21, 2019 8:43 am The MSCI world does not include emerging markets. So I would look at that one first.

To the question of whether or not you need more diversification; do you find yourself worrying about a downturn or the price swings?
Thanks for pointing that out. The actively-managed funds I hold (Scottish Mortgage IT and Monks IT) both have EM exposure so I'm comfortable not adding a specific EM fund.

I'm not hugely worried by a downturn with such a long way to go until retirement, but a I do worry about making rash decisions if there was a drop of 30% or more hence the bond allocation.
Topic Author
danielbird193
Posts: 36
Joined: Thu Mar 21, 2019 2:15 pm

Re: Sources of diversification for UK-based investors

Post by danielbird193 »

Valuethinker wrote: Tue May 21, 2019 8:58 am The choice of ISA and pension is critical. Assuming you are in a defined contribution or SIPP scheme then order of contributions is:

- pension first to the extent of the employer match
- full ISA allowance for self and spouse
(possible Children's ISA etc)
- remainder of annual pension allowance as long as your projections keep within the £1m (+ inflation) lifetime limit. George Osborne pulled the largest tax rise I have ever faced with that sleight of hand - nicely nailing those who had money in pensions, but not yet enough money to go for protection (i.e. over £1m)
This is a really helpful reminder. I should have pointed out that all my investments are held in either a SIPP or ISA (I have a generous employer contribution to the SIPP but also top up the ISA monthly from disposable income). Disposable income is not yet high enough to move on to the third of your bullet points!
Valuethinker
Posts: 41129
Joined: Fri May 11, 2007 11:07 am

Re: Sources of diversification for UK-based investors

Post by Valuethinker »

danielbird193 wrote: Tue May 21, 2019 9:47 am
Valuethinker wrote: Tue May 21, 2019 8:58 am The choice of ISA and pension is critical. Assuming you are in a defined contribution or SIPP scheme then order of contributions is:

- pension first to the extent of the employer match
- full ISA allowance for self and spouse
(possible Children's ISA etc)
- remainder of annual pension allowance as long as your projections keep within the £1m (+ inflation) lifetime limit. George Osborne pulled the largest tax rise I have ever faced with that sleight of hand - nicely nailing those who had money in pensions, but not yet enough money to go for protection (i.e. over £1m)
This is a really helpful reminder. I should have pointed out that all my investments are held in either a SIPP or ISA (I have a generous employer contribution to the SIPP but also top up the ISA monthly from disposable income). Disposable income is not yet high enough to move on to the third of your bullet points!
7% return doubles every 10 years. That means if you have £125k now you will hit that cap in 30 years (however if you presume the cap is still being indexed to inflation, it's a little less grim - say 2% inflation and 5% real returns).

In actual fact all the rules will have changed by then - if we have a change of government expect some kind of capital tax. Also *any* new Chancellor will take a look at that 250k tax free allowance - that's an obvious thing to tax.

People do not realize the scale of that tax grab, and the freedom to withdraw post age 55 is another windfall for the Chancellor which will keep on giving -- all the evidence shows that people overvalue lump sums v. monthly income (annuities) and so will withdraw too much, too early. You see echoes of that in the "4% Safe Withdrawal Rate" conversations around here - that number was set when interest rates and prospective returns were a lot higher than they are now.

Pensions are, I think, basically a duck sitting in the water, waiting to be blasted. It's far too much tax revenue left on the table, and generally a subsidy to the higher paid, and the average citizen does not understand a tax rise on pensions in the way they understand a rise in the Basic Rate.
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