Investors who want to keep some exposure to the UK, but also seek an element of regional diversity, could consider a FTSE All-Share ETF or tracker.
It’s hard to think of another event in recent memory causing more uncertainty for UK businesses than Brexit. Following the vote in June 2016, the FTSE All-Share index has underperformed the global benchmark MSCI World by 6.3% in annualised terms.
Some argue this makes UK companies a prime objective for bargain-hunters. However, investing in businesses that are particularly reliant on the health of the British economy remains a risky bet.
How badly can Brexit hurt UK companies?
As we write, no one knows what path the Brexit process will take. Even if the withdrawal deal is approved, the UK is in for a transition period when the future relationship will have to be negotiated, in effect meaning that uncertainty is likely to continue to weigh on investment decisions, stock valuations and the value of sterling. The alternative scenarios, of the UK crashing out of the EU without a deal or of a second Brexit referendum, also do little to mitigate uncertainty.
One thing is certain, though: to date, the added risk created by the Brexit process has not been good for UK stocks that are more heavily reliant on home market revenues. Domestically oriented UK firms have significantly underperformed stocks with greater international revenue diversity.
This highlights the importance of considering where companies earn their revenues when considering geographical risk. This is particularly relevant when investing in passive funds, because traditional equity indices attribute companies’ geographical distribution based solely on their legal domicile. This is not a good way of seeking to understand where the true sources of risk lie.
Turning the revenue lens on UK stocks shows a very different picture of the true geographical risk exposure of buying a UK equity index fund or ETF.
According to our calculations, only around 27% of the FTSE All-Share index’s revenues come from the UK. By contrast, the S&P 500 index’s revenue exposure to the US is a high 62%. The UK stockmarket has one of the smallest home country biases in terms of revenue out of all the major global markets, thanks to the large number of international businesses with global operations that are legally domiciled here.
The picture for the mid and small-cap FTSE 250 and FTSE Small Cap indices is very different, however. Nearly half of their constituents’ profitability depends on the business these companies conduct on home turf.
Using this ‘revenue origination’ approach, it would seem that investors in ETFs and index funds keen to retain or increase their allocation to UK companies but eager to minimise the impact of Brexit uncertainty on returns, could be better served by funds tracking the FTSE All-Share index.
Two silver-rated FTSE All-share passives
UK investors have a broad choice of funds that track the FTSE All-Share index. Holding over 600 stocks, the portfolio covers nearly all UK stocks. The top holdings include Royal Dutch Shell, HSBC and British American Tobacco, with weightings of around 4-8% each. The index is also well-diversified across different sectors. The highest weighting is towards financials (17-23%), followed by consumer staples (14-18%), energy (11-14%), industrials (9-11%), consumer discretionary (9-11%), and materials (9-11%).
The SPDR UK FTSE All-Share ETF charges only 0.2% and it is the cheapest ETF available to UK investors. For those who prefer to invest in a traditional mutual index fund, the best option is the iShares UK Equity Index Fund, with an ongoing charge of only 0.06%. Both funds have had a minimal level of tracking error, and we have a positive view on the portfolio management teams. Both funds carry a Morningstar Analyst Rating of Silver.
Dimitar Boyadzhiev is an analyst, manager research, passive strategies at Morningstar.