Looking under the bonnet to see where the convictions of managers lie
Sector definitions dictate that UK equity funds are required to have at least 80 per cent of total assets invested in UK-listed firms. There are, however, no limits on where their revenues originate. With the outcome of Brexit still largely unknown, it has never been more important to understand the level of exposure to the UK economy.
It is only by digging into a portfolio and gaining an understanding of the regions where firms source their revenues that a more comprehensive picture can be drawn. Using Morningstar’s new Revenue Exposure by Country metric, we compared funds in the UK Equity Income, UK Large-Cap Equity and UK Flex-Cap Equity categories with the FTSE All-Share index. This has enabled us to identify how UK funds are placed to cope with different Brexit outcomes.
It is no secret that many UK firms, in particular the largest 100, derive a significant portion of their revenues from abroad. The FTSE All-Share’s UK revenue exposure was only 27.7 per cent as of February, meaning more than 70 per cent of the revenues earned by its constituents came from elsewhere. Looking at funds across all three categories collectively, we found the average UK revenue exposure stood at 37.5 per cent, with 85 per cent of funds having a higher revenue exposure to the UK domestic market than the index.
Table one gives the average revenue exposure by category and shows that Flex-Cap Equity and Equity Income had a much higher UK revenue exposure than the index. Funds in the Large-Cap Equity category were, on average, more exposed to UK revenues than the index, but to a smaller extent. This can be partly explained by the average market cap of the funds, as large firms tend to earn more revenue from abroad.
With more than 70 per cent of FTSE All-Share revenues deriving from overseas, the relative performance of sterling can have a meaningful impact on constituents’ share prices.
A weaker pound typically benefits companies whose revenues and dividends are paid in non-sterling.
While our data set does not go back far enough to demonstrate it, we would expect the relative performance of funds with a greater UK revenue exposure than the index to be positively correlated to the strength of sterling and vice versa.
Believers and doubters
At the individual fund level, we have identified those with the highest and lowest UK revenue exposure in each category. The top and bottom three are identified in tables two and three.
With more than 70 per cent of its revenues deriving from the UK, Omnis Income & Growth is highest in the Flex-Cap sector. This fund is managed by Neil Woodford, who first turned strongly bullish on the UK domestic market back in Q2 2017. At the other end of the scale is Neptune Income, with a 17 per cent exposure to the UK. The fund’s manager, CEO and founder of Neptune Robin Geffen, does not favour his home market.
This is confirmed by a similarly low revenue exposure in his other UK fund, Neptune UK Quarterly Income (21.8 per cent).
What does it mean for investors?
Companies with the majority of their revenues deriving from the UK have significantly underperformed their more global-facing counterparts since the 2016 referendum. This has reflected the market’s dislike of uncertainty and, arguably, its attempt to price in the impact of a disorderly no-deal Brexit. While there are a number of potential Brexit outcomes, we have considered the two extreme scenarios and their implications.
Hard/disorderly no-deal Brexit
Assuming this results in a further depreciation of sterling and a sizeable economic downturn, funds with a lower UK revenue exposure relative to the index and peers would likely benefit from a tailwind.
Assuming a soft Brexit or the unlikely event of the UK remaining results in sterling appreciation and a more benign environment for British firms, we expect funds with a higher UK revenue exposure relative to the index and peers to experience tailwinds and have a greater chance of outperformance.
We expect a fund’s UK revenue exposure to have a meaningful impact on future relative returns.
With most active equity funds overweight UK revenue exposure relative to the FTSE All-Share, we would expect the average fund to face performance headwinds in light of a disorderly Brexit and vice versa. However, it is important to remember this is only one factor when considering active UK equity funds, and we have no real visibility on the actual impact of each outcome.
Ultimately, our findings serve as a reminder of the importance of understanding to exactly what you are exposed when investing in a fund.
Bhavik Parekh is associate analyst for manager research at Morningstar