A very large global technology company and a very large global bank might make up equally large parts of an index. But it can be argued that their exposure to different outcomes is entirely different.
The technology equity might be an enormous beneficiary of a low growth, low interest rate future, while the bank equity might benefit from higher interest rates, higher economic growth and higher inflation.
Given the increased correlation of asset class performance in recent years, there is a perfectly credible argument to say that, at this point in time, diversification of sectors is more important than asset classes.
Too much diversification is a bad thing, of course, because the administrative costs associated with buying a large number of small investments start to become prohibitive and there is a danger that too much tinkering damages the risk/return trade off. But if you do not diversify enough, you do not gain access to a broader range of outcomes that are available to the better-informed investor.
This is the same across both equities and bonds. On the equities side, our view is that focusing on tracker funds in the UK brings with it an unacceptable level of risk when UK tracker funds especially are dominated by old world giants in oil and gas, mining and banks, with little or no technology to balance this out.
Look behind the index
When the index is overvalued, the key is to look behind the index at individual sectors or companies that for some reason are out of favour. It is obvious that one of the main drivers of recent equity valuations has been the extraordinary performance of the large US technology stocks. The Microsofts and Alphabets (Google) of this world can look expensive for the very good reason that they are extremely well-run businesses, producing prodigious free cash flow that looks set to continue to grow well into the future.
It is best to hold a portion of a client’s portfolio in global leaders with defensive economic characteristics, but alongside this to search for more out-of-favour sectors. Good examples of these are large pharmaceutical companies that trade on cheap valuations and have been shunned by investors who remain worried by a Biden presidency and perceived risks surrounding reforms to the Patient Protection and Affordable Care Act 2010 and attempts to reduce drug prices in the US.
An ageing global population in a post-pandemic world with increasing wealth is going to want access to more medicines, and for this reason alone it seems big pharma represents a good long-term investment bet. Similarly, the US household name banks who obviously suffered during the pandemic are starting to pay dividends again and remain dominant in their industry.
