How Nutmeg manages UK home bias

Pacome Breton


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Nutmeg is a UK based wealth manager with mostly UK-based clients, and this is reflected in our investment process giving a specific importance to UK assets. Here we explain what this means for our portfolios and how we manage this aspect of our investment strategy.

 

Nutmeg’s long-term global strategic asset allocation philosophy

Nutmeg uses a core strategic asset allocation philosophy to create and manage diversified multi-asset portfolios with a long-term horizon. Our long-term strategic asset allocation (SAA) serves as a base methodology to guide our fully managed and SRI portfolios, as well as our fixed allocation portfolios. Our SAA is the anchor of our allocation guidelines and essentially the foundation for our investment universe, which prescribes our investment philosophy.

The Nutmeg SAA is based on a pragmatic approach using quantitative tools which use long-term data to create stable, robust and attractive portfolios containing assets diversified by regions, and currencies.

The market capitalisation of each region we invest in is crucial to the final construction and management of our SAA framework and every year we reassess this framework with the latest market capitalisation data.

This analysis informs how we manage our home bias. Our portfolio range is offered with the UK pound as the base currency and to mostly UK-based investors. Consequently, in working out our long-term allocation to UK equities, more parameters were added into the equation than for any other region.

What drives our home bias?

Currency

One of the main reasons to consider our UK allocation in comparison to our global allocations is currency management.

The UK is the only equity market denominated in pounds and the only one where there is no need or benefit for Nutmeg to conduct active currency management. Our investments in other equity markets require us to consider the potential impacts of investing in different currencies and the potential movement of local currencies; these can, of course, be beneficial if the local currency increases in value but can also create negative drag if the local currency depreciates.

Foreign equity allocation can be hedged but the cost of hedging, embedded in the hedged share classes of ETFs, can be a drag on performance. While the cost might be almost negligible in certain currencies, it can become important when there is a large interest rate differential unfavourable to the pound.

The UK’s economic context and equity yields

As well as the macro economic environment, we also look at a number of aspects which relate to the specificity of the UK equity market. UK large cap equities derive a rather significant portion of their revenues from outside the UK. The FTSE 100, which is the most common large cap equity index, is estimated to derive more than 65% of its revenue from foreign sources making it the second most international index after the Swiss equity market.

Historically, the FTSE 100 has been the index offering the highest dividend yield of all developed markets, typically between 3.5% to 4.5% (source: Nutmeg/FTSE). While this is not, per se, a determinant feature, as long-term equity return is a mix of dividend yield and stock appreciation (for which the FTSE has not seen the same outperformance), it makes it attractive for liability driven investors like large pension funds, retirees and insurance companies. With the stability of dividends being a large portion of long-term equity appreciation in the UK, it doesn’t come as a surprise that large cap UK equities have a lower volatility than other markets in Europe, the US or Asia. This tends to make the UK more resistant during drawdowns and periods of volatility.

In addition to the benefits of UK large cap, the UK equity market benefits from a dynamic small and mid-cap environment represented by the FTSE 250 index which has offered superior risk adjusted return over the long run. The specificity of the FTSE 250, with its many investment trusts and a strong focus on the local economy and real estate, adds some positive points to our consideration towards home bias.

Benchmarking

Another theme in our framework is the importance of the UK equity allocation among our competitors and in particular our main benchmarks provided by the UK wealth management industry aggregator ARC (Asset Risk Consultants). Data provided by the IMF and MSCI shows that a typical equity portfolio for UK investors advised by a private wealth manager held around 33% UK equities at the end of 2018 vs 67% held in foreign equity. 

Areas to watch

As well as the reasons listed above, there are a number of negative aspects we consider in deciding our level of home allocation. First and foremost, the size of UK large cap equities in world indices has reduced through time and this trend has continued since 2015, when we designed our original SAAs. (source: MSCI). The sector mix of UK equities, and their limited exposure to technology stocks, has been a drag on its performance as the banks and the material and energy companies that make up UK indices have not benefitted from the economic dynamics that have rewarded other indices. However, these dynamics can change; this is why we look beyond short-term data to derive our optimal allocation.

How we finalised our home bias

In order to effectively derive our home bias, incorporating the pros and cons we have listed here, we start by taking the long-term average UK weighting in global stock markets – though adjusted based on recent data and the presence of overseas revenues. We then bring in the different statistical benefits such as lower UK volatility, as well as drag factors such as less attractive sector components.

A final optimisation looks outside the UK at the characteristics of foreign equities and determines how the impact of foreign currencies can give us an optimal long-term allocation. This relative allocation is scaled up or down further depending on the risk profile a client selects. This reflects the need for lower risk portfolios to benefit further from the stability of UK equities and their lower foreign currency exposure.

The end results

Taking all of these considerations into account, our long-term strategic allocation to UK equities ranges from 6.3% for a risk level 2 fully managed portfolio, to slightly less than 20% for a risk level 10 fully managed portfolio, (though the equity allocation is lower in absolute terms for the lower risk portfolios due to their limited total equity allocation, it is higher in proportion to non-UK equities). And if we take the highest risk level as an example, while 20% is significant enough to have a meaningful impact , it also means that up to 80% of that allocation remains in foreign equities.

 

Risk Warning

 

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.

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Pacome Breton
Pacome is an investment manager and head of risk at Nutmeg with more than ten years' experience in investment and risk management. He previously worked for a US family office and a large European asset manager and started his career at Société Générale in Tokyo. He holds an MSc in quant finance from Bocconi University in Milan and is a certified financial risk manager and chartered alternative investment analyst.

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