Large-cap focused ETFs look well-placed to weather sterling volatility.
Since June 2016 the uncertainty surrounding Brexit has weakened the pound and turned the UK stock market into an uncertain place for investors. Over this period the FTSE 100 index has lagged the MSCI World index by 2.1% a year and experienced around 10% more volatility.
Market volatility may drop away once the dust settles on a Brexit deal. However, reduced economic growth is probably here to stay. The protracted Brexit negotiations have already resulted in delayed projects, restructuring costs, lost jobs due to relocations and deteriorating business confidence. Investors with UK allocations can expect reduced profits and dividend cuts in the short to medium term.
Against this backdrop, the question lingering in many investors’ minds is whether they should adjust their UK exposure. The easy way for them to eliminate these risks is to simply reduce their allocation to UK stocks, or do away with it completely. However, investors would then miss out completely on any returns in the event of a positive Brexit outcome.
Before making any rash moves, it will pay investors to consider which UK companies they are currently exposed to. UK-based multinationals such as HSBC and AstraZeneca are better positioned to navigate tough local market conditions than small, UK-focused companies such as Ocado, although the latter are more likely to benefit in the event of a Brexit ‘bounce’.
Exchange traded funds that track broad market indices such as the FTSE 100 and FTSE All-Share have a heavy tilt towards larger companies and would be suitable for providing ‘defensive’ exposure to the UK. The Morningstar silver-rated SPDR FTSE UK All Share ETF is one of the best tools for the job. It holds all companies that are listed in the UK, but it still invests more than three quarters of assets in large- or giant-cap companies.
Looking into revenues can provide a helpful guide to how vulnerable a company is to an economic slowdown in the region it operates in. This approach is more useful than considering a company’s domicile, which is taken to be the country where a company’s headquarters is located. Returning to our previous examples, both HSBC and Ocado are run from the UK, but the pan-global nature of HSBC’s business means that UK-centric Ocado is, relatively speaking, much more sensitive to domestic woes.
ETFs that track the large-cap focused FTSE 100 and the FTSE All-Share indices offer good protection against an economic slowdown in the UK, as only 20-25% of large-cap aggregate revenues are sourced domestically. This contrasts with small- and mid-cap companies, where typically around 50% of revenues come from the local market.
Be mindful of ETFs’ costs
|L&G UK Equity ETF||0.05|
|Xtrackers FTSE All-Share ETF||0.20|
|SPDR® FTSE UK All Share ETF||0.20|
|UBS ETF MSCI United Kingdom||0.20|
|UBS ETF MSCI UK IMI SRI||0.28|
While the cheap pound is not ideal for holiday-goers, multinational companies that transact in multiple currencies stand to benefit in several ways.
The most significant contribution comes from selling products and services overseas. When doing so, a company collects its revenue and pays its expenses in a foreign currency, but it reports its profits in pounds.
A cheap pound also makes UK exporters more competitive. For example, manufacturers of export products, ranging from cleaning products to aircraft engines, will receive more pounds for their inventory. That further supports a tilt towards larger UK companies for as long as Brexit uncertainty persists.
Being mindful about investment costs is crucial for long-term success. Charges for ETFs tracking market indices with broad and deep coverage of the UK market start from 0.05%.
Dimitar Boyadzhiev is senior analyst, manager research passive strategies, at Morningstar.