Bring out your dead… UK equities

The brief revival of UK equities in 2022 feels like a distant memory this summer – the AI frenzy has aided US equities on a relative basis and the sense of doom in the UK continues. There are plenty of lazy headlines resurfacing about how the UK equity market has become a global backwater, awash with companies and investors that lack vibrancy. Alongside a suggestion that UK politics is comparable with Emerging Market nations, one can create a compelling narrative that the UK market is nearing the grave. Look a little closer however, and there are important hallmarks of longevity that should continue to keep capital flowing in.

In terms of property rights and rule of law the UK looks to be in a good place. The political system allows governments and leaders to come and go in a relatively healthy and orderly fashion. The Treasury also has a strong track record of collecting taxes and let’s not forget the benefits of its time-zone and location.

The AJ Bell approach

From an AJ Bell perspective, the long-term health of the UK is important to monitor as our portfolios have a reasonable weighting to UK equities, which brings several benefits. When it comes to asset allocation for UK-based investors and those likely to have liabilities in sterling, investing in the domestic market can help reduce currency risk, cost and tax.

Currency risk is an interesting concept. The assumption that the companies listed in the UK are priced in pound sterling and therefore negate currency risk is a fallacy. Revenues and cost bases are often global in nature, especially amongst large caps, bringing about translation effects that can work against the intention of the asset allocator. Put simply, profitability and therefore market pricing can be dictated by the performance of the pound; weakness in the currency can be a tailwind for those generating revenues in another currency and vice versa, a dynamic particularly acute for those with large cost bases in the UK. This frequently plays out in the dispersion of returns from the FTSE 100 and FTSE 250, with the latter traditionally composed of more domestic revenues. In practice, measuring and managing around the translation effect is nigh impossible given the multitude of factors impacting company accounts. Corporate hedging policies and the fact that accounts are only a point-in-time snapshot of corporate activity provide ample hurdles. At the very least, it can be said that having a home bias provides a degree of reduced currency risk and diversification.

Costs are more straightforward. Investing in domestic equities is legally efficient for a UK investment vehicle and as such a plethora of products is available. Intertwined with the legal side are execution costs; trades take place on venues operating heightened liquidity during UK business hours and days, and most often in sterling (avoiding the need/costs of currency conversion). Access to the US market is, however, almost equally cheap and easy.

Tax is principally about the treaty status between the UK and the country of domicile, where the dividends or interest payments originate. Withholding tax for example is taken at source, and for dividends coming from US-listed investments is levied at 30% for UK investors. This can be reduced via a series of forms and reclaims, however it acts as a drag on performance for active and passive investments alike. This barrier to return generation, albeit small given some markets are not particularly focused on dividends, gives the UK market an advantage for UK investors. It must be mentioned that synthetically constructed products can navigate this tax, however they come with an additional degree of complexity.

Fear of missing out

To address the suggestion that the UK is falling behind when it comes to attracting businesses to list in London, there is an element of being careful what you wish for. Longstanding research in the US¹ suggests over 50% of IPOs between 1975 and 2018 gave a negative buy and hold return three and five years after issuance and that over five years they lag comparable stocks by 2.4%² per annum, not including the return achieved on the first day of issuance. This can be accentuated at times when markets appear overly enthusiastic. Those that took part in some of the ‘blockbuster’ IPOs of 2021 and held on are nursing heavy losses, with an average one-year return of minus 49.2% from the 311 stocks that listed³. Two of the most spectacular flops came to market via direct listings, merely allowing the share to trade in a secondary market rather raising proceeds as a traditional IPO would. Coinbase, the crypto exchange, and Rivian, the electric car maker, had market caps of $38 billion and $12 billion respectively at launch and have since seen their share prices fall 75% and 84% (as of 22/08/23).

The US is widely regarded as having poorer corporate governance than the UK, allowing founders a lot of control relative to other investors and a remuneration regime that can be described as grotesque. Some of the high-profile UK IPOs that have produced particularly poor returns for shareholders of late have leant towards corporate governance and culture standards akin to the US, with the UK government particularly keen to relax the rules in certain circumstances. A common idiom used by longstanding investors is that avoiding losing money is one of the keys to achieving good long-term returns.

The perception that the UK capital market is falling behind has prompted several UK market participants to abandon allocations in favour of a more global approach over the past decade. On an unhedged basis, which is most often the case, this introduces additional and rather needless volatility into portfolios in the hope of chasing returns. This has paid off handsomely in recent years, as most of the global allocation sits in US equities, but is not guaranteed to continue.

The AJ Bell approach

Here at AJ Bell Investments, the current SAA allocates 26%-30% of overall equity exposure to the UK (6%-25% at an overall portfolio level), which compares with some global equity benchmarks typically holding 3-4%. This is by no means the most aggressive home bias. Our 2023 Capital Market Assumptions (CMAs) suggested that UK equities were priced to provide some of the best long-term returns, particularly relative to the US, and come with a lower level of volatility than areas such as Emerging Markets and Asia Pacific. This somewhat contrarian view, and a possible change of global economic and market regime due to higher interest rates, could prove to be a key performance differentiator going forward. Towards the end of the year the AJ Bell CMAs will be recast, however given their mechanical nature it is not difficult to predict that they will continue to flag good value on offer in the UK market. The question will be when the catalyst to realise this value arrives.