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I am a newbie investor and just've opened my first trading account although haven't invested in anything yet.

I want to invest solely in index funds.

In the book "A Random Walk Down Wall Street" at the page 202 there is a diagram that shows how risk changes with diversifying a portfolio by mixing domestic stocks with foreign stocks.

The example in the book shows an example from the USA - 84% of S&P500 with 16% MSCI EAFE.

What would be an example for the UK?

Can anyone give me an example of such diversification based on Index Funds available in the UK?

Or better yet, how can I search for products myself and calculate the risk?

I know this is a very loaded question, but any tips are greatly appreciated.

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  • Pairs trading is a neutral strategy that involves a long and short position in highly correlated securities where you seek to trade the spread. What does the reference to that in your title have to do with the discussion of indexes and diversification in your question? Are you seeking info on pairs, the other two, or all three? – Bob Baerker Jun 13 '18 at 13:10
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    @BobBaerker The word "pair" above was used quite literally to refer to a set of two things, and not used in the context "pair trading". But anyway, I've modified the title so it won't suggest "pair trading". – Chris W. Rea Jun 13 '18 at 16:12
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    @matewilk - I'm not sure if you're trying to duplicate the S&P500 / MSCI EAFE mix with UK funds or if you want to set up an allocation based on the UK market. Either way, there are many web sites that provide a list of US ETFs, mutual funds and CEFs as well as for checking their correlation with each other as well as with major US indexes. I would imagine that something similar should be available in the UK. Find the lists, determine correlation to the Indexes you wish to invest in and allocate according to the diversification ratio you seek. – Bob Baerker Jun 13 '18 at 16:47
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    "Pairs trading" is a technical term for an activity that you don't seem to be asking about in this question. I may be wrong, but I doubt it. Bob is talking about having a view that (for example) Pepsi stock is cheap compared to Coke, but you don't have a particular view on the beverage market as a whole... so buying Pepsi WHILE shorting Coke would be a market neutral pairs trade. This has nothing to do with portfolio diversification that you're asking about. – David Jun 14 '18 at 13:28
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    @timday, yes, it is going to be ISA of course. – matewilk Jun 16 '18 at 12:26
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Non-US investors have to be a bit careful when interpreting material written for US investors for their own markets. The US market comprises ~54% of global market cap (in indices like MSCI World or FTSE World), while the UK is only 6%, so an investor in the USA who invests 84% in domestic markets and 16% abroad actually has a very different exposure to a UK investor who invests 84% in the UK and 16% abroad (in that case the US investor would end up far more globally diversified than the UK investor did).

Firstly I'd question whether you even need two funds. Buying an MSCI All World or FTSE World tracker (fund or ETF) gets you fantastic global diversification in equities. If you then add more equities in specific sectors or regions, all you're really doing is choosing to "overweight" something rather than diversifying further. These days my favourite global index fund is Vanguard's FTSE Global All Cap Index Fund as the FTSE Global All Cap Index reaches further into the mid-cap/small-cap end of the markets than other global indices do (so, more diversification).

For two investments allowing you to tweak the relative balance of domestic and international exposure (which is presumably what the book you mention is describing), a good couple might be Vanguard's FTSE U.K. All Share Index Unit Trust together with their FTSE Developed World ex-U.K. Equity Index Fund. (However, that wouldn't actually give you any emerging market exposure, so if diversification is your goal then you'd probably want to add an EM tracker too). Another option might be to hold a global tracker - which will include some UK exposure - and then just add more FTSE UK All Share to take your "home bias" up to what you want it to be.

(Of course even broader diversification might come from adding things like fixed interest and "alternatives" like property and commodities, but the example you mentioned was equities so I assume that's what you're focussed on.)

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  • +1, though I don't think mentioning property (to which the vast majority of people are way way overexposed) or commodities (highly debatable as an alternative), even in scare quotes, adds to the answer – David Jun 15 '18 at 7:09
  • @David Tim meant commercial property which in the UK you hold via closed end funds eg TR Property – Neuromancer Jun 18 '18 at 10:59
  • @Neuromancer Unless there is a low or negative correlation between residential and commercial property in the UK (I haven't checked, but I'd doubt it a priori), if you're already way overexposed due to owning a house (perhaps leveraged with a mortgage), adding commercial property exposure via a fund is going in the wrong direction, no? – David Jun 18 '18 at 11:42
  • OK maybe I should have missed that bit out! I just wanted to raise with the OP (identified themselves as a newbie, clearly interested in diversification - they mention the word twice - and yet apparently limiting themselves to stock indices) the idea that broader diversification might be achieved through exposure to different asset classes rather than just exposure to different equity markets. The question of if and when property exposure (of any type) is a useful diversifier and to what degree it's correlated to other asset classes is an interesting one though; has it ever been asked here? – timday Jun 18 '18 at 14:07
  • It may be too specific to hyperlocal property price movements, which don't have good publicly available data in most areas, to have useful answers here. An analysis would work using REITs or similar, but the usefulness of any answer using property funds will be limited to those individuals whose home does not form a significant portion of their net worth. – David Jun 18 '18 at 15:29
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There seem to be two questions here: first how to choose your desired percentage allocation, and secondly how to implement that in the UK. Answering the second first:

In the UK, this will depend heavily on the platform through which you are investing. If you are investing via a SIPP or ISA, you will generally be constrained to those funds that the provider has a deal with to provide at a reasonable price. Fees in general are eye-watering compared to the US, so it will be wise to constrain yourself to whichever fund providers are advantaged in that sense. All that I'm aware of will offer index funds from some provider, look for either "index" or "tracker" in the name of the fund.

If you are talking about a regular, taxed, brokerage account, you may be able to access US ETFs directly (though you may incur a paperwork burden by having to file US taxes in order to reclaim taxes withheld in the US).

It may be wise to first choose your intended geographic/sector/whatever breakdown by using tools on somewhere like ETFdb or Morningstar and then finding corresponding funds on your platform...

But if your question is actually how to choose the percentage weights of your desired allocation, that's advice for which you would be wise to seek a financial advisor. Just be aware that most equity markets are reasonably highly correlated most of the time, so minor differences in allocation weights are not going to make huge differences in your expected risk or return. Depending on whether you subscribe to Modern Portfolio Theory or not, you (read: "your advisor") could obtain the historical returns for your various ETFs and then construct the covariance matrix, using it to then find an "efficient portfolio" in some sense, then decide whether you wish to take active bets based on that efficient mix of assets. You will likely find, if you pursue this, that unless you use some relatively sophisticated statistical techniques (lookup "covariance shrinkage"), that your answers will vary wildly depending on exactly where you cut off your historical data... Whether this all becomes a bit of a fool's errand is ultimately up to you. You might find it more productive to figure some relatively simple global weights and then not worry too much about it!

What you should not do is allocate based on your confidence in the economy of a country or countries. Nobel laureates who do this for a living show a poor track record of gaging economies, you are unlikely to do better than them. Buying based on your confidence is exactly why people buy high and sell low. And in any case, even if you had a crystal ball and perfect discipline, economies and stock markets are only correlated in the very long term.

You may find articles like http://www.crainswealth.com/article/20161021/WEALTH/161029985/5-top-wall-street-investors-weigh-in-on-the-best-ways-to-invest helpful to formulate your own thinking, but again: formulating your desired portfolio allocation will be a different question to how to implement it, especially in the UK. And I said it before, but it bears repeating: watch out for fees!

None of this is financial advice and I am not your financial advisor... and I hesitate to recommend any specific product or platform, but since you mention a predilection for index funds, you may or may not know the story of Jack Bogle and Vanguard, who are reasonably famous for championing low cost index funds (since well before it was "cool"). You may be interested to know that Vanguard has a UK platform and you can apparently open an ISA with them.

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  • David, thank you for your post. Yes, I have already registered with the cheapest broker I could find on the market, their ongoing fee is 0.25% which includes a platform charge of (0.20%) and their ongoing fee of 0.05%. On top of that, there is, of course, a fund charge which varies. Registering with them gives me access to Fidelity's FundsNetwork where there are thousands of products to choose from. – matewilk Jun 16 '18 at 12:33
  • @matewilk is this for an ISA? If it's a regular brokerage, you should not be paying any ongoing fees or platform charges. Anyhow, it was the fund charges to which I was referring. For various reasons I cannot open an ISA so I am not familiar with them first-hand... but I see that ongoing charges are a thing, since Vanguard charges 0.15% I doubt anybody goes much lower than Vanguard as a general rule. – David Jun 16 '18 at 12:47
  • yes, Vanguard is the cheapest, although, in the UK, you need to invest at least £100,000.00 to be a Vanguard customer. I have already researched the market and sent an email to Vanguard to which I got a response stating the amount just mentioned. Yes, it is for an ISA. Not sure how it is in the US, but in the UK no fees is not an option I'm afraid until I don't know some important details? I've read a few books on investing so far, and of course, I am aware of the fees.I'll be investing in the cheapest index funds, no more than 0.1% fee. – matewilk Jun 16 '18 at 12:55
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    It may be a moot point because you're already with Fidelity, but you may have gotten slightly mixed up. They might require a minimum of £100K to open a regular account; but they seem to accept ISA customers from as little as £100 per month or a £500 lump sum vanguardinvestor.co.uk/investing-explained/stocks-shares-isa – David Jun 16 '18 at 12:58
  • It's not too late, I haven't invested yet. I'll take a look, thanks for the link! – matewilk Jun 16 '18 at 13:00
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Different Kinds of Diversification

There's not a "optimum" diversification that one can select - diversification protects against specific kinds of risks, and therefore depends on your risk assessment.

You can diversify by owning different stocks within the same sector. You are protected from the risk of - say - the Volkswagen emissions scandal by purchasing other auto makers.

But what if the auto industry as a whole declines? You may invest in a broader array a stocks - say by purchasing shares of an S&P 500 index - to protect against a decline in one sector.

But the S&P 500 is a group of American stocks - there is a risk that the American economy will decline. You can mitigate that risk by investing in other countries' companies.

But the US economy is one of the faster growing economies in the world, and you're protected from the risks of investing in potentially volatile developing economies. So the balance you select in a "total world" portfolio is really your assessment of what countries you think are going to grow their economies best in over the time period you are investing. There's not consensus to be had on that answer, because no one knows!

Practicalities

Two major things you should look into are: Fees and taxes.

In the US a fee of ~ 1% is high for an index fund, and a fee around ~0.15% is probably reasonable. Fees may differ depending on how much you invest, what kind of work goes into creating the index, etc.

You may also face additional taxes or fees for investing in foreign stocks. This will be very location dependent.

Anything More Specific Depends on You

It is difficult to give good advice on diversification that is specific to your position. It's mostly a matter of your risk tolerance, and risk assessment.

If you are confident in the UK economy, find a UK equivalent of the S&P 500 and don't worry about it.

If you're worried about the UK economy - say because Brexit makes you nervous - then look for more international funds. Again, which countries you choose to invest in and in what ratios depends heavily on how you think those economies will perform over time.

I'd shop around on different brokerage websites. They will provide a breakdown of holdings for each fund - x% large companies, y% small companies, p% local, q% international, etc. Find combination of funds that make you feel confident and has low fees.

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    I don't get why, if you're specifically confident in the UK economy, you'd look for an S&P 500 (i.e. US-centric) fund rather than say, a FTSE 100 fund. Also, risk tolerance should have very little impact on your choice of geographic allocation except perhaps for EM/FM funds... Japan (or Switzerland, or Germany), say, is not inherently more volatile than the US. Finally, the whole answer seems oblivious to the fact that the person is UK based: the tax-free nature of ISAs will dwarf any "shopping around" for a normal brokerage account for 99.99% of investors. – David Jun 14 '18 at 22:09
  • I also don't understand why you lead by suggesting diversifying by owning different stocks in the same sector. Firstly, you could argue that buying two stocks in the same sector is the textbook definition of not diversifying, and secondly, the OP asked specifically about using only index funds. – David Jun 14 '18 at 22:38
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    @David a) by S&P equivalent, I mean a broad index of the UK economy. I'm not aware of what the UK equivalent would be, so I don't try to offer one. b) I'm trying to illustrate that diversification has levels to it. That's why those paragraphs begin with "but" - I'm pointing out a flaw in the previous strategy. The point I'm raising is: "What risk is the OP trying to mitigate through diversification?" The investment strategy to mitigate a downturn is different depending on the downturn - global, regional, local, by sector, by industry. All are different. – codeMonkey Jun 14 '18 at 23:02
  • Also, allocating based on your confidence in an economy is a poor strategy. I've updated my answer. – David Jun 15 '18 at 6:52
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    Also "there's not a "optimum" diversification that one can select" : you could argue that that's the very definition of the Markowitz efficient portfolio. – David Jun 15 '18 at 7:14

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