Broaden your horizons

By February 29, 2024Financial Planning

The news that the UK economy fell back into recession at the end of last year is likely to be of little comfort to investors whose portfolios are heavily weighted towards UK Equities. It is fair to say that most UK investors will have some exposure to shares listed in the FTSE100, the index of the largest quoted UK companies. Indeed, we often come across portfolios that continue to hold a heavy concentration of UK Equities, and this is particularly true of traditional Discretionary Managed portfolios, which hold a blend of directly held shares and collective investments.

Investors who have focused on UK shares are likely to have seen an extended period of underperformance compared to investors who have adopted a global approach to investment. The FTSE100 index level has increased by just over 7% over the last 5 years, which is disappointing when compared to the performance of other global indices over the same period. Over the last 7 calendar years, the S&P500 index of leading US shares has outperformed the FTSE100 in each period, with the sole exception being 2022, which proved to be a very disappointing year for most asset classes. Moving away from the headline FTSE100 index, the performance of mid-sized UK companies in the FTSE250 index has been weaker still.

Structure of the index

One reason for the extended period of underperformance of the FTSE100 is the composition of the index itself. At the end of 2023, just under 20% of the FTSE100 is represented by financial companies, with Consumer Staples being the second largest sector. Industrials, Energy and Healthcare are the next three largest sector allocations. Over recent years, much of the outperformance of global markets has been led by stocks in the technology sector, which are significantly underrepresented in the FTSE100 index, with just over 1% of the index allocated to Tech stocks. By way of comparison, close to 30% of the S&P500 is invested in the Technology sector.

London losing its’ lustre

Another factor that is influencing the performance of UK indices is the diminishing influence of the UK in global financial markets. In 2022, the market capitalisation of French listed companies temporarily exceeded those listed in the UK for the first time. Further damage to London’s reputation has been caused by a number of leading domestic companies who have chosen to list on global exchanges rather than list on the London Stock Exchange. These include semiconductor stock ARM, who listed on the NASDAQ index last September. If this trend continues, the gap in performance between the UK and global markets could widen further.

Positive for income seekers

The above factors paint a rather gloomy picture for domestic shares. There are, however, a number of redeeming features which suggest that investors would be unwise to shun UK Equities altogether.

For investors who are seeking a high level of dividend income, the FTSE100 can be a happy hunting ground. The current yield on the index is around 3.7% per annum, which represents a significant uplift over the yield on the S&P500 index, which stands at just 1.3% and is also higher than the yield generated by the indices of our major European counterparts. The composition of the FTSE100 lends itself to an attractive dividend yield, due to the high concentration of mature companies that are cash generative. Furthermore, UK companies have a long-standing culture of returning excess profits to shareholders in the form of dividends.

Whilst UK stocks tend to offer the most attractive yields, many investors now choose to focus on total return from their investments, which combines capital appreciation or losses achieved in conjunction with dividend income received. Given the modest capital performance over the last five years, using this measure reduces the attractiveness of the FTSE100 dividend yield.

Investors seeking income can also broaden their horizons, as Global Equity Income funds increase in popularity. These funds, which are typically actively managed, invest in global stocks that offer attractive and sustainable dividend yields, and whilst it is fair to say that other geographies don’t share the dividend culture present in the UK, many mature companies listed in the US and Europe still offer attractive yields. Adding Global Equity Income to a portfolio can be a useful way of diversifying a highly concentrated exposure to UK companies.

Cheap for a reason?

The UK market is certainly attractively valued when compared to global markets. The forward price-earnings ratio – a well-known measure of whether a stock or index is cheap or expensive – stands at around 10 times earnings. This is less than half the price-earnings ratio of the S&P500 index, and indicates the UK is certainly cheap compared to US markets. The FTSE100 price-earnings ratio also stands at a discount to the same ratio for the major German and French indices.

Given the discount to other global markets, why have UK stocks continued to underperform? Perhaps the answer is that UK stocks are cheap for a reason, given the stagnation in the UK economy and lower appeal in the current market trend towards technology stocks.

The benefits of diversification

Over recent years, holding a high allocation to UK Equities may well have led to underperformance as UK shares have lagged their global counterparts consistently for an extended period.

Whilst UK Equities remain attractively valued, the FTSE100 is poorly placed to take advantage of current market momentum, which is very much focused on new industry and technology in particular. A swing in market sentiment, however, towards more value orientated companies could help UK indices regain lost ground, and this is why retaining exposure to the UK remains appropriate in a diversified portfolio. There are, however, compelling reasons why investors, who hold significant allocations to UK shares, should broaden their horizons and seek to diversify into other geographies, such as the US and Far East.

Our experienced financial planners can review an existing investment portfolio and suggest areas where greater diversification could be beneficial. This can be particularly important for those who hold portfolios that have not been reviewed for some time. Speak to one of the team to arrange a formal review.