Globalisation and growing dominance of US stocks have reduced potential for wealth managers to add value at regional and country level.

We recently polled our universe of discretionary fund managers (DFMs) asking for their split between domestic and non-domestic equity exposure. The results of this survey confirmed a trend for sterling-denominated portfolios towards the adoption of a global approach for management of equity exposure.

Naturally, over the past decade, such an international approach to equity investing has clearly been beneficial. However, the rise in interdependency of regional economies, the dominance of US stocks within global equity markets and the increased stock-specific concentration of the US market have presented DFMs with several new challenges.

For starters, there is the shrinking benefit of geographical diversification. As global economies have become more interdependent, it follows that they have also become more correlated, especially during periods of economic instability. That brings into question the benefit of risk diversification by country or region.

Second, there is the dilemma of geographic asset allocation. Put simply, the dominant weighting of US stocks within the global market makes tactical asset allocation by geography problematic. Meaningful country tilts have effectively become a binary bet on the US market.

And third, is the stock selection conundrum caused by the increasing concentration of the US equity market, personified by the so-called Magnificent Seven. By the end of last year, US stocks made up almost three-quarters of the global developed equity market by market capitalisation, up from approximately 47 per cent around the time of the global financial crisis in 2008. The Magnificent Seven alone made up close to a quarter of world equity market capitalisation.

Crunching the numbers

These factors prompted us to question whether it was a time for a rethink on how to approach asset allocation. And so, we decided to crunch some numbers to find out.

One way of looking at the concentration of a data set, usually applied to the number of stocks within a portfolio, but equally applicable to the number of countries or sectors in an index, is the ‘effective count’. An equally weighted portfolio holding two stocks would have an effective count of 2. If the two stocks were held with a ratio of 90:10, the effective number of stocks would be just 1.2 as one stock dominates the portfolio. The 23 countries that make up the global developed market have an effective count of just 1.8. Compare this to sector weightings, focusing on the 11 main sectors, where the effective count is 7. This finding suggests that thinking about sectors rather than countries leads to more potential for diversification.

Our research also showed that while countries correlate very closely sectors do less so. For example, the correlation between the IT sector and the energy sector is -0.1, which is an inverse correlation, the holy grail of diversification.

How sectors improve diversification by being less correlated

And then there is the potential for better outcomes at the sector level. Our analysis, using Monte Carlo simulations, showed that the dispersion of possible outcomes (the opportunity set) is significantly greater for portfolios managed tactically at the sector level than at the country level, emphasising the positive impact of moving to a sector-based allocation model.

The potential for better outcomes was also evident when comparing the range of estimated return contributions for portfolios managed by DFMs within the ARC Indices. The regression analysis showed that when considering global equity exposure from a regional perspective, the only significant decision is whether to position the portfolio as underweight or overweight the US.

Viewing with new lenses

On the other hand, viewing the same exposure through a sectorial lens provided more insight and brought with it more opportunity for a DFM to add value through tactical asset allocation across those sectors.

We are not arguing that selecting sectors should completely replace tactical asset allocation at the country level. After all, sector and country exposures are not mutually exclusive. Yet, our analysis reveals that thinking about global equity tactical asset allocation, with sectors as the starting point, provides a greater opportunity to make meaningful tilts away from the index – without necessarily taking on significant country risk versus the index, or (unintended) bets around the Magnificent Seven.

To quote the Dalai Lama: “Our world has greatly changed: it has become much smaller. However, our perceptions have not evolved at the same pace; we continue to cling to old national demarcations.”

When it comes to asset allocation, perhaps we should heed his words. It is time for perceptions to evolve and for sector exposure to be more carefully considered, at a minimum in parallel with geography.

Shaun Le Messurier, client director at ARC Research