Fund tips: how investors can play a range of Brexit scenarios

The latest Brexit thinking from a range of investment experts.

Brexit uncertainty stifled the UK stockmarket last year, making it one of the poorest-performing markets around the world. The fortunes of individual funds were largely tied to one factor:  whether their holdings were domestically orientated or export-focused.

“In 2018, having a domestic bias was a significant detractor, as investors shunned the UK, while companies whose revenues came primarily from overseas did much better in general,” says Nick Wood, head of investment fund research at Quilter Cheviot.

All UK equity sectors – UK all companies, UK equity income and UK smaller companies – lagged the FTSE All-Share index. Equity income was the best performer of the three, having endured a period of poor performance over the previous couple of years. “The more established, large-cap nature of many income stocks explains this,” says Wood. The UK smaller companies sector, on the other hand, lagged due in part to its domestic bias.

The primary driver determining which UK funds should do well and which poorly in 2019 is likely to be the type of Brexit that eventually materialises.

Soft­ landing

Despite the tumult in UK politics, a soft Brexit – one that leaves the UK closely aligned with the EU and with access to the single market, and sees UK businesses minimally affected – remains the base-case scenario, though some delay is now (as of mid-March) almost inevitable. In such an eventuality, sterling is likely to rally, boosting domestic corporate earnings prospects. That would be of greatest benefit to the UK smaller companies sector, given that it has the largest domestic market skew.

Stephen Peters, a UK equities analyst at Barclays Wealth Management, reckons that Merian UK Smaller Companies and Merian UK Mid Cap should “do really well”. He points to the strong reputation and track record of the UK smaller companies team at Merian Global Investors.

“Performance has been good, although 2018 was a difficult year for the mid-cap fund in particular, the final quarter being especially tough,” he says. “Greater economic clarity could be a real boon.”

The larger-cap-focused UK all companies and UK equity income sectors invest in companies that produce most of their earnings in dollars and euros. Edward Park, an investment director at Brooks Macdonald, says: “Should we see a market-friendly Brexit, these foreign earnings would become less attractive in sterling terms [as the pound strengthened], so we would expect this to lead to relative underperformance compared with the smaller companies sector.”

While that may be true at a headline level, in the event of a soft Brexit, value stocks – which have arguably been unfairly punished by the market and are trading at lower prices relative to their fundamentals – could also make a comeback. The UK equity income sector has historically had more of a value bias, because above-average yields often indicate a company is out of favour for some reason and its share price has therefore fallen. Funds in this sector with a domestic focus stand to benefit.

For Architas investment manager Jen Causton, JOHCM UK Equity Income and Chelverton UK Equity Income fit the bill. Both have relatively high exposure to sterling earnings. Causton says: “JOHCM’s sector bets include financial services, which are much more domestically orientated post the financial crisis, and construction and materials. Importantly, the fund has relatively high exposure to small- and mid-cap stocks, and it favours some of the valuations on offer in small-cap stocks in particular.

She adds: “Chelverton only invests in smalland mid-cap stocks and, unlike the average small-cap manager, looks for ‘boring’ and steady companies that are often overlooked in favour of growth disruptors.”

Brewin Dolphin recommends UK all companies sector funds, which should profit from sterling strength as well as a wider ‘Brexit bounce’ as global investors return to the unloved UK market. Head of fund research Ben Gutteridge highlights Man GLG Undervalued Assets and Investec UK Special Situations as being well-positioned to take advantage of this dynamic.

Six funds well-placed to benefit from a soft Brexit

    Total return (%) over:    
Fund 6m 1yr 3yr 5yr
Merian UK Smaller Companies -12.14 -7.91 46.47 58.18
Man GLG Undervalued Assets -0.25 0.81 41.51 43.15
JOHCM UK Equity Income -3.23 -2.41 32.02 29.01
Merian UK Mid Cap -14.84 -11.01 30.00 50.31
Investec UK Special Situations 1.85 6.38 26.30 20.96
MI Chelverton UK Equity Income -7.30 -2.84 24.57 37.46
IA UK Smaller Companies sector -10.40 -5.20 35.31 37.23
IA UK All Companies sector -3.17 0.48 25.68 24.71
IA UK Equity Income sector -1.95 0.89 20.61 24.81

Notes: Ranked by three-year total returns. Source FE Analytics, as at 8 March 2019

Hard hitters

A hard Brexit, where the UK ends all its agreements with the EU without a transition period, is deemed by our experts to be less likely than a soft Brexit. But if a no-deal Brexit were to occur, funds with big exposures to larger UK firms that derive a lot of their revenues from overseas should hold up better than domestic names, given that the pound is likely to slide against other currencies in such a scenario.

Gutteridge rates such firms and also those with quality characteristics and resilient business models such as LF Lindsell Train UK Equity, a UK all companies fund run by the seasoned UK investor Nick Train. He concentrates the portfolio in 20-35 durable household names such as Unilever and Burberry.

Another option for investors is a simple large company tracker. Wood says: “If one were seeking the greatest exposure to companies with strong overseas revenues, a FTSE 100 tracker would offer a significant bias in that direction, as the FTSE 100 strips out the small and medium-sized companies found in the FTSE All-Share index.” Ben Yearsley, a director at financial adviser Shore Financial Planning, uses the Legal & General UK 100 Index, which costs a mere 0.1%.

FundCalibre, the fund ratings and research provider, regards UK equity income funds that derive a lot of their income from overseas as the best options for a hard Brexit. With the UK stockmarket yielding around 4.5%, investors get paid an income for hanging on in there.

Moreover, funds with an income focus tend to favour companies that are less sensitive to economic cycles and less affected by recession. This makes them a “good defensive place for investors to shelter from the storm”, according to Adrian Lowcock, head of personal investing at Willis Owen.

Morningstar analysis shows that Troy Trojan Income and Franklin UK Equity Income derive the least revenue from the UK, at 35% and 40% respectively. That compares with 45% for the UK equity income sector as a whole. “These two funds are large-cap focused, where foreign revenues tend to be high,” says Jonathan Miller, director of UK manager research ratings.

Darius McDermott, managing director at FundCalibre, reckons a hard Brexit could pay off for Evenlode Income: He says: “It has a lot of overseas exposure and its managers look for companies that should be affected least by short-term economic issues.” It is among the five top-performing UK all companies funds since the Brexit vote in June 2016.

Five fund suggestions for a hard Brexit

      Total returns (%) over:    
Fund IA sector 6m 1yr 3yr 5yr
TB Evenlode Income UK all companies 2.01 10.90 42.72 66.86
Lindsell Train LF Lindsell Train UK Equity UK all companies -1.76 9.11 40.56 67.15
L&G UK 100 Index Trust UK all companies 0.88 4.77 32.35 28.33
Franklin UK Equity Income UK equity income 1.08 6.36 29.34 42.83
Trojan Income UK equity income 0.17 6.60 16.74 37.81
IA UK All Companies TR in GB   -3.17 0.48 25.68 24.71
IA UK Equity Income TR in GB   -1.95 0.89 20.61 24.81

Notes: Ranked by three-year total returns. Source FE Analytics, as at 8 March 2019

Outcome trap

Of course, other Brexit outcomes are possible, including a second referendum or a revocation of Article 50. Patrick Thomas, an investment manager at Canaccord Genuity Wealth Management, says: “Investors and markets have been warned many times not to bet on binary outcomes, but they seem to keep falling into the same trap. There is a worrying narrative around UK equities and Brexit, and we would urge a degree of caution.”

Peters also expresses concern. The overwhelming consensus view from most of the UK equity fund managers he speaks to is that there will be a deal and that it will bode well for the out-of-favour UK stockmarket. “I’m personally a little worried by the degree to which the ‘if there’s a deal, it’s all positive’ view has become a consensus,” he says.

He adds: “Some have argued that post-Brexit the UK government will pay more attention to fiscal stimulus, but perhaps it’s wishful thinking to believe a Brexit deal would be an end of some kind – it will likely just turn out to be the end of the beginning when you consider the difficult trade negotiations ahead. European economies are slowing, and a few people are talking about a UK recession. I’m not predicting this, but it’s interesting that the possibility is so rarely mentioned.”

For Thomas, any manager who calls Brexit right will have “got lucky and is probably not running the fund you want to own long-term”. He advocates backing managers with identifiable ways of running their portfolios that mean they will be resilient across outcomes. He rates Alex Wright at Fidelity Special Situations for his contrarian approach and ability to add value.

For a natural hedge, FundCalibre suggests a multi-cap UK equity income fund such as LF Gresham House UK Multi Cap Income or Marlborough Multi Cap Income. Parts of these funds should hold up well in different scenarios.

Yearsley suggests a specialist approach for riding out Brexit, whatever the outcome. FP Foresight UK Infrastructure Income and TIME Defensive Income Securities invest mainly in UK-listed renewable infrastructure. “They are income-generating and have solid inflation-linking, so they shouldn’t be affected by Brexit either way,” he says.

Five funds to weather a range of Brexit scenarios

      Total return (%) over    
Fund IA sector 6m 1yr 3yr 5yr
FP Foresight UK Infrastructure Income Specialist 7.83 17.41 n/a n/a
LF Gresham House UK Multi Cap Income UK equity income -5.65 1.98 n/a n/a
TIME Investments Defensive Income Securities Specialist 4.41 n/a n/a n/a
Fidelity Special Situations UK all companies -4.27 0.45 32.41 38.33
Marlborough Multi Cap Income UK equity income -3.09 -0.57 15.89 25.50
IA Specialist sector   0.84 0.12 32.48 31.85
IA UK All Companies sector   -3.17 0.48 25.68 24.71
IA UK Equity Income sector   -1.95 0.89 20.61 24.81

Notes: Ranked by three-year total returns. Source: FE Analytics, as at 8 March 2019

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