I had assumed that the high correlation between UK and overseas equity markets meant that I could get exposure to the latter simply by holding UK tracker funds.
This has not entirely been the case, though. Although changes in UK equity prices closely track changes in overseas ones, the UK has underperformed the rest of the world. Measured in US dollars, UK equities have risen only 38 per cent in the past five years compared with a 66.7 per cent rise in the MSCI world index. My home bias has therefore cost me a lot. In fact, the All-Share index, in US dollar terms, is now close to its lowest level since 1977 relative to the MSCI world index.
This poses the question: why has the UK lagged behind so badly?
There's a simple answer here. Just four things can explain over half of the considerable annual variation in UK equities relative to the MSCI world index since 1991. These are:
■ The MSCI index itself. When this rises, the All-Share tends to underperform; the UK market is relatively defensive. Given that the MSCI index has more than doubled since its low point in early 2009, this accounts for a lot of the UK's underperformance.
■ Commodity prices. When the S&P/GSCI rises, the All-Share tends to underperform. You might think this surprising, given that the UK market has a big weighting in commodity stocks. But it's not. There's a strong correlation between commodity prices and emerging market equities. When commodities rise, emerging markets tend to do well, which drags up more developed equity markets. These are circumstances in which the relatively defensive UK market tends to underperform the rest of the world.
■ The $/£ rate. When sterling rises, the All-Share index tends to do well in dollar terms. Confidence in UK equities and in sterling tend to rise and fall together.
■ Bond yields. When 10-year gilt yields rise, the UK tends to underperform. But when 10-year Treasury yields rise, the UK tends to outperform. This is probably because expectations of tighter monetary policy - which tend to drive yields up - are bad for equities.
However, even if we control for these things, the UK market has underperformed the MSCI world index - by 0.8 per cent per year. That might not sound much. But it's statistically significant and, compounded over 25 years, economically significant, too.
Although these factors have done a good job of explaining variations in the UK's relative performance in the past, they cannot fully explain its recent underperformance. In the past 12 months, the UK has underperformed the MSCI by 11.1 per cent, but these factors predict only 3.4 percentage points underperformance.
I suspect that one reason for this is simply idiosyncratic bad performance by a few big stocks. It's not just giant mining shares that have done badly recently but also stocks such as BP, Tesco and Glaxo. These are so big, and their price falls so significant, as to drag down the UK index generally. The same thing helps explain why the FTSE 100 has underperformed small-caps.
There are two ways of reading this. You could see it as a sign that some UK mega-cap stocks have grown too big and so are suffering from diseconomies of scale. Or you could see it as just bad luck. Many companies run into trouble from time to time, but it just happens to be big UK ones that have done so recently. The former explanation points to the UK continuing to underperform, the latter to it not doing so.
My suspicion is that it is the latter. Gibrat's law - the idea that growth is independent of size - tells us that we shouldn't expect big stocks to continue to underperform. If they did so, we'd eventually end up with an economy in which all companies were the same size. That's not likely.
For this reason, I suspect that unless we get a sharp rise in world stock markets or in gilt yields or the US dollar, the UK might not continue to underperform the rest of the world by very much.
