The Brexit Effect: How Sectors and Factors Fared in UK Equity FundsTuesday 27th June, 2017
A year on from last June’s shock Brexit referendum result, negotiations have begun on the terms of Britain’s exit from the European Union. Shortly after the 2016 vote, we discussed the likely economic impact of Brexit, the investment factors anticipated to emerge most strongly, and how managers were positioned to respond. In this update, we review the past twelve months’ activity in three ways:
- How has the UK market behaved – which sectors and factors performed best over the period?
- How are domestic UK equity funds oriented, and how have they changed since last year?
- Which funds performed best, and what drove their returns?
A YEAR SINCE BREXIT: KEY TAKEAWAYS
- Market Performance: Basic Materials, Technology and Oil & Gas were best performing sectors in UK market, at expense of Consumer Services and Telecoms & Utilities
- Factor Performance: Value factors came out ahead – for both unadjusted and sector-neutral portfolios; Growth, Low Volatility and Momentum performed poorly in unadjusted portfolios
- Fund Orientation (Factors): Compared to pre-Brexit, main orientation changes are moderation of anti-value biases, greater exposure to historic growth factors and momentum, and a move into more volatile stocks
- Fund Orientation (Sectors): Minor sector adjustments towards Industrials, away from Oil & Gas, and a reduction in the overweight to Consumer Services
- Best Performing Funds: Stock-picking primarily accounted for returns – two-thirds of best-performing funds added more value from stock selection than sector allocation
In the immediate aftermath of the ballot, it was generally expected that the UK economy would slow, Sterling weaken, and inflation pick up. At that point, we highlighted the factors that could benefit in those conditions, such as Cashflow-based Value, Dividend Yield, Quality Growth (ROE, Margin), Gearing and Foreign Sales.
As it turned out, GDP growth remained robust, at around 2%pa, though the latest quarterly figure was revised down to 0.2% for Q1 2017. Recent surveys point to a slowdown in consumer spending (a large part of UK economic activity) as average wages have remained subdued, and inflation has reached a four-year high of 2.9%pa. The split decision by UK policymakers to hold interest rates at 0.25% reflects the challenges of a 2%pa inflation target whilst maintaining growth in the current environment. So, whereas the most pessimistic forecasts of ‘remainers’ have not come to pass, and a recession is not expected, more moderate growth is on the cards over the short term, with inflation expected to rise higher through 2017.
Against this background, the UK stock-market has been very resilient – the FTSE All Share index providing a total return of 24.5% in the twelve months ending May 2017. With the USD/GBP rate falling 14% from its pre-Brexit level, the Basic Materials sector was the biggest beneficiary, beating the index by nearly 40 percentage points. Technology has also had a good run, as did Oil & Gas. Telecoms and Utilities lagged however, and the Consumer Services sector underperformed.
Given the big sector swings, factor return patterns depend crucially on how factor portfolios are constructed. For this article, using Style Research Markets Analyzer, we focus on the largest 600 UK companies and form cap-weighted portfolios taking the top 50% (top 80% for Size) ranked by each factor. We show the relative returns for one year ending May 2017 below, both for unadjusted and sector-neutral versions of the factors.
Factor Returns since Brexit (May 2016 – May 2017)
When sector-adjusted, the quality Growth factors of ROE and Margin did quite well, indicating that there were opportunities available for stock pickers to target such stocks on an intra-sector basis. Though there were weak returns for Momentum and Low Volatility, these were also likely to be sector efforts masquerading as factor returns – the sector-adjusted versions were flat. But exporters outperformed (Foreign Sales factor), whether sector-adjusted or not.
FUND ORIENTATION – FACTORS
Given these factor returns, how were funds positioned over the period? We investigate using Style Research Peer Insights, with a focus on the Investment Association UK All Companies peer group benchmarked against the FTSE All Share Index. Using holdings data (sourced from Morningstar) for around 200 funds, we show the Style Research Peer Skyline™ for this peer group.
Style Research Peer Skyline™ for domestic UK funds, Apr 2017, sector adjusted
Several features can be identified from this picture. In general, funds are more anti- than pro-Value oriented. Apart from Earnings Yield, where fund exposures are more evenly distributed around the benchmark, the other tilts show a clear bias away from Value. Dividend Yield stands out – where almost three-quarters of the peer group have below benchmark yield. The picture is more nuanced for Growth factors. Whereas most managers are biased towards historic measures of Growth (Earnings and Sales), there appears to be a split in terms of current measures of profitability – this peer group is more tilted towards higher ROE but also to lower margin stocks.
The other exposures reveal some distinct factor orientations. Many funds have a smaller cap and domestic bias. Most notable are the exposures to Short-term Momentum, and away from Returns Stability (Low Volatility). It seems that managers are happy to invest in recent winners. It is also instructive to view how these tilts have changed over the year. The chart below shows the factor exposures for the median fund both before the Brexit vote and more recently.
Median (sector adjusted) Style Tilt™ for UK domestic equity funds, pre-and post Brexit vote.
The median tilt has not shifted a great deal for most of the factors. The main changes over the year have been a moderation of some of the anti-Value biases, greater exposure to historic Growth factors and Momentum, and a move into more Volatile stocks (more negative bias to Returns Stability).
Except for ROE, none of the median exposures align with the best-performing factors over the year. In general, funds missed out on the Value rally in the second half of 2016, were the wrong way around on the Growth factors, and were too domestically oriented, given the boost to exporters from the falling pound. Broadly speaking, the funds in this peer group were not oriented to benefit from the factor moves witnessed since last June .
FUND ORIENTATION – SECTORS
What about sector positioning? The chart below shows the latest peer sector distribution across the funds.
Active Sector Weights for UK domestic equity funds Apr 2017
These positions have been reasonably consistent since the vote, with a small shift over the year towards Industrials and away from Oil & Gas, and a reduction in the overweights to Consumer Services. Once again, the group does not appear well-positioned to have benefitted from the sector returns through the year. Managers have done well with overweights in Technology and underweights in Utilities, but have missed out on much of the large potential returns in Basic Materials. They were also wrong-footed by the weakness in Consumer Services stocks.
Despite these observations, about a quarter of the peer group did outperform the benchmark over this period. To determine whether sector or factor exposures were a determinant of their success, we narrowed down the peer group to just those funds that bettered the market return. The Style Research Peer Skyline™ for this cohort of approximately 50 funds is shown below.
WHAT DROVE OUTPERFORMANCE?
Style Research Peer Skyline™ for best performing funds since Brexit
Other than a little more exposure to Medium-Term Momentum (which makes sense, since this group of funds has invested in the best performers over the year), there is little difference from the broader peer group. There is a similar picture for the sector exposures, which also resemble those of the full peer group.
Generally, these top funds achieved their returns from elsewhere – by stock-picking. Closer examination of the best-performing subset reveals that the median fund held fewer stocks, and had higher active share and (ex ante) tracking error than the rest of the funds. They also had a greater proportion of their risk from bottom-up as opposed to top-down sources of risk.
More detailed analysis of the sources of performance is also revealing. Using Style Research Enterprise Portfolio Analyzer, we break down each fund’s outperformance into returns from sector allocation vs. stock selection within sectors. This confirms the above intuition regarding the importance of stock selection for the best-performing funds, and we find that two-thirds of this group added more value from stock selection than sector allocation.
We also use the Style Mine to assess which factors delivered positive returns for each fund. Less than a third of these top-performing funds had their factor exposures the right way around over the period. Again, it was stock selection that delivered the returns. With closer monitoring of their factor and sector positions, these funds would likely have performed even better.
As Brexit negotiations begin in earnest there will likely be plenty more turns in the road, and the final settlement is anybody’s guess at present. Though Prime Minister May’s hand has been weakened following her poor showing in the snap election on 8 June, and the prospects of a hard or ‘no deal’ Brexit have diminished, the spectrum of potential economic outcomes is very broad. What is certain is that there will remain plenty of opportunities for investors of all types, whether factor, sector or stock-picker based. And those who keep a close eye on their fund exposures will have the advantage.