Investing in alternatives
Investment trust expert MAX KING provides an introduction to the fast-growing alternative assets sector. (First published in 2018 and not updated but still very relevant).
According to Simon Elliott of brokers Winterflood, only 55% of the investment funds sector is accounted for by funds investing in equities. The remaining 45% – and the fastest-growing part of the sector – is accounted for by funds investing in ‘alternatives’ to equities. This growth has been fuelled by an insatiable demand for high-yielding funds. Charles Cade of brokers Numis estimates that alternatives accounted for 65% of issuance in the sector in the first half of 2018, after 76% in 2017 and 85% in 2016.
Lumping all these investment companies into a single category risks masking the diversity of where and how they look to make money. The alternatives sector comprises a number of quite different vehicles. The main sub-sectors are property, debt instruments, infrastructure, private equity and renewable energy. In addition, there are specialised companies that invest in niche areas such as aircraft leasing and music rights.
There is clearly no lack of choice – and, if this rate of expansion continues, alternatives will soon be dominating the whole investment funds sector. Some caution is advisable. History shows that issuance of new trusts is often the result of investment fashion as much as of soberly-judged opportunity, and fashions tend not to last. None of the Lloyds insurance vehicles launched in the 1990s, for example, now survive; they turned into insurance companies before being taken over. The listed hedge funds or funds-of-funds which were popular a decade ago are steadily disappearing as a result of disappointing returns. A number of the income funds launched in the last ten years have recently hit pockets of turbulence or worse.
Nor are alternatives a new phenomenon. Many of the UK’s oldest investment trusts, including FOREIGN & COLONIAL (dating back 150 years) and SCOTTISH MORTGAGE, were not founded to invest in equities but in fixed-interest securities. They switched from ‘alternatives’ to equities along the way and would probably not have survived if they hadn’t. Living up to the promises and projections in terms of investor returns made at launch has always been a challenge, especially as the world changes.
Driven by the search for income
There is little doubt what has powered growth in recent years: it is the search for income. Negligible interest rates and very low bond yields have compelled investors to look elsewhere for income to live off. Equity income has been popular, but investors have also sought assets which have a low correlation to equities (which are assumed to be volatile and risky). The one thing you can rely on is that whatever investors want at any one time, the eggheads in the City will always provide.
The core problem for investors is that when interest rates and bond yields are low, a fund that pays a yield of 5, 6 or 7% without drawing on capital has to be taking a lot more risk. Its investment return before costs will be even higher unless returns are leveraged up with debt, which is risky in itself. Unfortunately, there appears to be a behavioural flaw in the thinking of many investors; they assume that the yield, if not its upward progression, is guaranteed. This is certainly the belief of a fund’s managers and sponsors, but it doesn’t always work out that way. If things go wrong, or the rules and regulations change, the danger is that a promised payout will be cut.
Investors also forget the old adage that ‘a bird in the hand is worth two in the bush’. Turned around, it means that income now will be coming at the expense of rather more capital growth in the future. Ideally, investors would maximise total return (income plus capital gain) and be happy to draw on capital to supplement income, or to invest in funds that do that. But the Victorian belief that spending capital is a sure path to the poorhouse persists.
The reality is that income certainly matters, but so does income growth – and it is the latter which is the driver of future capital gains. With capital gains subject to taxation only on sale, and even then only outside SIPPs and ISAs, investors should logically be happy to sacrifice some income for capital growth. But that is not the way fund flows into the trust sector have been running. So before investing in an alternative asset fund paying a generous yield in a world of 2% inflation, it is important to understand where the yield is coming from and how sustainable it is.
Gauging the risk of a particular trust is not always easy. Be extra careful when there is an assurance, implicit or explicit, that a trust is somehow ‘low risk’. Don’t automatically assume that those managing or promoting a fund fully understand the risks behind their business models.
Breaking down the risk spectrum
At the top end of the risk spectrum sit listed private equity funds. Many of these funds came a cropper in the financial crisis due to leverage and excess commitments to new investment. Some were panicked into distress fundraising, some went into wind-ups and some ploughed on. Since then, they have, with one or two exceptions, prospered, benefiting from good underlying performance and narrowing discounts to asset value. In some cases, returns have been spectacular. Although the private equity cycle is now well advanced, there could well be more to go for. According to the Financial Times, the private equity industry worldwide has $2trn of uncommitted funds to invest, meaning it’s a better time to sell assets than to acquire, but managers have learned their lesson and become more cautious than in previous cycles.
The sector divides into direct investors and funds which invest in a range of unlisted private equity funds. The higher visibility of the investments of the former generally results in lower discounts to net asset value. Asset values are usually conservative and out of date so value is often better than it appears. Funds such as 3I, HG CAPITAL and (until Edward Bramson seized control) ELECTRA, which consistently sold assets at large premiums to book value, demonstrated this. They have been the ones to own, while those that sold at poor prices or failed to sell, such as CANDOVER and BETTER CAPITAL, have been poor investments despite being available on enticingly wide discounts.
Funds-of-funds suffer from an extra layer of fees, but they provide a diversity of managers and access to funds otherwise not available to most private investors. An average return of 75% over five years is impressive and suggests that the double-digit discounts at which all five of them have been recently trading may be unwarranted.
The private equity sector is shrinking with seven funds in ‘managed wind-up’ and one (Candover) already gone, compared with just one recent arrival – APAX GLOBAL ALPHA in 2015 – with the highest yield in the sector at over 6%. The trusts in managed wind-up offer a guarantee that their discounts will disappear as the date of wind-up approaches, but they cannot guarantee how well their investments will perform, not least because the remnants of their portfolios – the ‘orphan assets’ they have not so far managed to sell – are likely to be among their least successful investments.
Also investing in private equity are a few specialist funds such as RIVERSTONE ENERGY and SYNCONA. Riverstone invests in oil and gas fracking prospects and projects in North America; given how strong oil prices have been in 2018, the flat performance of its shares and the persistent double-digit discount to net asset value must count as disappointing. That could not be said of Syncona, which is transitioning from what was an innovative investment fund-of-funds to a UK-focused investor in early-stage life-science companies. Its shares have risen 50% in a year.
One of the most remarkable fund issues of 2017 was the raising of over $500m of new money by CATCO, which uses its capital for catastrophe reinsurance. This was in the wake of a disastrous sequence of hurricanes and fires which halved its share price. Presumably, investors who subscribed for the new shares blamed the weather rather than the managers. Catco has always been open about the risks in its business, but investors may have been lulled by the high yield paid in good times.
Possibly less risky but also promising high yields are the £720m BIOPHARMA CREDIT fund, which is investing in the debt, secured on royalties, of life sciences companies, and HIPGNOSIS SONGS, which recently raised £200m to buy catalogues of old songs. Whether either fund has secured the right deals to deliver the promised returns over time remains to be seen.
Infrastructure funds have come in for considerable criticism not so much for taking excess risks as for being overpaid for the supposedly low risks of privately-financed investment in the UK public sector. The high returns have largely been the result of falling bond yields which made the income streams from these projects, secured for up to 30 years, especially attractive, but the politicians who were once desperate for this investment don’t like being made fools of. Dire retribution is threatened, regardless of signed contracts.
This type of project accounts for a diminishing proportion of the infrastructure funds, who are busily diversifying into private sector and international projects while showing much less interest in dealing with the UK’s public sector. The long-term consequence will be a drying up of private capital for public investment in the UK but that is not a concern for investors. The recent bid for JOHN LAING INFRASTRUCTURE suggests that all the political scare did was create a long-term buying opportunity.
Less controversial are the infrastructure funds which focus on renewable energy. Investors have steadily overcome their initial suspicion of these new vehicles, meaning that they all now trade at premiums to asset value. The suspicion was based on the large subsidies that solar and wind power have needed to be economic, the cost of which is passed on to consumers in higher prices. But so long as the consumers haven’t noticed, or aren’t bothered by this hidden tax, then the politicians, hungry for green credentials, don’t seem to care. Anyway, the subsidies on new projects are falling as efficiency improves.
The funds investing in debt are returning to the roots of the investment trust sector. Some funds invest in fixed-rate debt, some in floating, some in long-dated income streams, some in short-dated. There are funds investing in high-yield bonds, distressed debt, unlisted loans and regulatory capital for banks. There is no emerging market debt fund, but that is probably not for want of trying. The diversity reflects the ebb and flow of sentiment towards fixed-interest securities and trends within the market rather than a campaign to cover all bases.
They all offer attractive yields but the opportunity for income growth and hence capital gains comes largely from retained earnings, which in turn depends on the skill of the managers. Yields are higher when the income is secured on specified assets rather than on the company as a whole, justified by the struggles of some funds whose security turned out to be faulty. Is the 6.9% yield on UK MORTGAGES too good to be true or a bargain? Its manager, TWENTYFOUR ASSET MANAGEMENT, is well regarded and manages two other listed income funds but the security of residential property could prove illusory in a recession.
The financial crisis and subsequent restrictions on banks led to a surge of interest in peer-to-peer lending. The result, inevitably, was the launch of six funds with £2.5bn of capital, appealing to those who prefer a collective vehicle to direct lending. Unfortunately, we will not know how good their credit control is until we have the next economic downturn. One fund has already had to make material provisions for credit losses, but it could be a mistake to be too cynical. The quality of credit control in commercial banks has always been low, particularly for smaller commercial and personal loans handled out of bank branches. These funds, helped by more modern IT, may be able to do it better.
Once upon a time, you had to be really rich to invest in hedge funds. These funds, discreetly boasting stellar returns, were famous for their exorbitant fees (a 2% annual management charge, plus 20% of all returns) and the doors were firmly closed to latecomers. Their managers billed themselves as the cleverest whizz kids on earth, enjoyed rock-star status and even greater riches. Then the exclusive clubs opened their doors to everyone, the mystique vanished and it was downhill all the way in terms of performance. Some managers were too rich to bother to come into work anymore, some lost their ‘magic’ touch, some failed to recognise that market conditions no longer favoured the strategies they had followed.
As a result the ranks of the investment trusts following hedge fund strategies grow thinner every year, but it may be too soon to write the sector off. Aftermseveral years of dull returns, BREVAN HOWARD posted a 9% return in the second quarter for its macro fund and 5% for its global fund, as some big bets on bond spreads in the eurozone paid off. Bill Ackman’s PERSHING SQUARE, whose fortunes peaked when it listed in Amsterdam in 2014, appears to have returned to earlier form after three down years. It still trades at a 23% discount to asset value.
The final segment of the alternative funds sector is property. Confusingly, many property companies are structured and taxed as ‘real estate investment trusts’ (REITs) but are not included in the investment trust sector. As a generalisation, property funds seeking to harvest the income from property ownership are in, while development companies which focus on adding value to their holdings are out – but this is not a hard-and-fast rule. SEGRO (out) has owned the Slough Trading Estate for 100 years, while F&C COMMERCIAL PROPERTY TRUST (in) has been a fairly active developer. Many conventional property companies also pay generous dividends and trade on large discounts to net asset value. They may prove a better investment than some of the property investment companies with high yields, which have less potential for added value and trade above net asset value.
Among the specialist funds, PHP (not in the sector), MEDICX (in) and ASSURA (not in) all own doctors’ surgeries on long-term leases which have been guaranteed by the NHS, making them comparable to infrastructure funds. IMPACT and TARGET HEALTHCARE do the same with care homes, but without the guarantee. EMPIRIC and GCP STUDENT LIVING own and rent out student accommodation, supported by partner universities but so does UNITE, the first operator in the area, which is a company rather than a fund. There are funds owning and leasing supermarkets, logistics warehouses and social housing; all of them promise a high and rising income, but with very different risks. The NHS will always pay for doctors’ surgeries, but care home operators can (and do) go broke. Well-located logistics warehouses may be irreplaceable, but student accommodation may not be. Housing associations should have access to cheaper finance than they can get through a listed fund.
Other property funds invest more broadly, focusing on generating an attractive and rising income from higher-yielding properties, plus an element of added value. Five funds invest in Europe of which two are focused on logistics warehouses and one on flats in Berlin, but the best exposure to Europe (62% with the rest in the UK) comes from TR PROPERTY, the only investment trust which invests in property company equities (93% of the portfolio) rather than directly into bricks and mortar (7%).
In conclusion, alternative funds are a disparate lot and investors need to tread carefully, thinking objectively about the sources of income and risk. High income does not come without risk and income growth is important for capital returns. Issuance is often a reverse indicator of future performance, so it is usually better to wait until they have proven themselves before investing. But alternative funds can also provide excellent opportunities. The shares of private equity fund-offends PANTHEON INTERNATIONAL, which sunk low in 2008, have since multiplied tenfold in value. There may be hidden jewels in what investors throw out, but all that sparkles is not gold.
MAX KING was an investment manager and strategist at Finsbury Asset Management, J O Hambro and Investec Asset Management. He is now an independent writer, with a regular column in MoneyWeek, and an adviser with a special interest in investment companies. He is a non-executive director of two trusts.
Taking the plunge
Investment trust expert MAX KING offers advice to private investors on how to benefit from closed-end funds. This article was first published in the 2018 edition of the Investment Trusts Handbook and has not been updated.
A significant proportion of the financial service sector operates on the assumption that savers are neither capable nor willing of looking after their own investments and so need help from the ‘experts’. Inevitably this help and all the regulatory encumbrances that accompany it are costly, eating into investment returns. There is often a strong bias towards sacrificing returns for what the professionals regard as lower risk, but which is, in reality, only a reduction in short-term price volatility.
People are accustomed to taking significant financial decisions such as buying a property or a car without paying for advice so why do they not take the same view of their investments? Taking the DIY plunge requires confidence and nerve, but it soon becomes much easier. The greatest dangers lie in getting carried away by success or despondent about disappointment, in letting personal emotions get in the way of sensible decisions and in being influenced by people whose job it is to entertain, scare or impress you, but not to make you money.
The best advice for all would-be investors was carved on the lintel of the doorway to the temple of the Delphic oracle thousands of years ago: “Know yourself ”. What works in investment varies from person to person. It takes time, experience and some uncomfortable mistakes to learn the rules which you are best suited to follow. Long ago I realised that I was happier investing my own money in funds rather than directly in stocks, bonds or private companies, despite the tax advantages of the latter. Many investors successfully combine all three, but investment funds have some distinct advantages so should form at least a significant part of most portfolios.
Firstly, they encompass a broad spread of underlying investments making them less vulnerable to individual stock disasters. Secondly, they are managed by professionals who are better able to keep abreast of corporate developments, their markets and the broader economy. Finally, with the professional manager taking the individual stock decisions, the investor in the fund can leave well alone, just monitoring its performance and keeping an eye out for signs of trouble.
Inevitably, there are costs attached to this, which means that if you pay a wealth manager to invest in funds for you, you are paying twice over. There is little more satisfying than picking a stock market winner based on an insight the professionals have missed – and few more salutary lessons, on the other hand, than seeing the value of an investment wiped out. Investing in funds reduces the incidence of either extreme.
Having decided to invest in funds, your decision to go for investment trusts or other closed-end investment companies rather than unit trusts (now called open- ended investment companies or OEICs) is an easy one. Numerous studies have shown that over all time periods, closed-end funds nearly always outperform comparable open-ended funds in each sub-sector of the market, even when the funds are run side by side by the same manager. There are several reasons for this: firstly, closed-end funds tend to have lower costs. Secondly, their managers can take advantage of gearing, borrowing for investment when opportunities are attractive and raising cash when they are not. Thirdly, fund managers find it easier to manage a fixed pool of money than a variable one. When an open-ended fund is doing well, new money floods in, forcing the manager to invest even though prices may be unsustainably high. When the market drops, money floods out and managers have to sell into falling prices. The risk of this also constrains the manager’s ability to invest in less liquid but perhaps highly attractive opportunities.
Another major advantage is that closed-end funds are governed by a board of non-executive directors who are independent of the management company. The management company may be more interested in growing funds under management and in keeping fees high than in performance, but the directors won’t be. If the performance is poor, they can negotiate a fee reduction, a change of manager or a move to another investment company. They will issue new shares only if it is to the advantage of all investors but can also buy in shares if they are cheaply priced. Finally, they scrutinise performance, cross-examine the managers and keep them on their toes far more effectively than happens under the internal governance of OEICs.
Of course, there are some excellent open-ended funds while some interesting segments of financial markets are poorly or not at all served by closed-end funds. On the other hand, there are some areas of the market where open-ended funds with daily liquidity simply don’t work because the underlying assets are too illiquid. Examples include funds investing in private equity, property and the fast-growing area of alternative assets. Alternative assets encompass funds investing in infrastructure, loans, aircraft, alternative energy and a growing list of other tangible or intangible assets. These funds generally offer a high yield, moderate dividend growth and the prospect of some capital appreciation. This makes them attractive relative to cash, corporate or government bonds and their consequent popularity has led to a flood of new issuance in recent years.
After a slow start, equity issuance in 2018 has accelerated but is unlikely to exceed the 2017 record. As last year, little of it is in the conventional equity space. Investors need to be wary of stock issuance whether for new or established funds as it is often opportunistic, driven by current investor fashion and of more benefit to the sponsors and managers than the investors. As shown in recent years by WOODFORD PATIENT CAPITAL and PERSHING SQUARE, the more popular the new issue, the worse the subsequent performance. But wariness should not extend to a full aversion; BAILLIE GIFFORD US has risen 30% since its flotation early in 2018.
Fund flows are far from being one way but good performance and low discounts mean that buybacks and liquidations are diminishing. Funds reach the end of their pre-determined lives, continuation votes are voted down, boards decide that the investment thesis no longer works and so wind up the company, or boards – whether of their own volition or at the instigation of activist shareholders – return capital to investors. In closed-end funds, disappointing performance usually leads to action but in open-ended funds it often leads only to stagnation.
A key indicator of disappointing performance, or merely that the fund’s investment focus is unappreciated or out of fashion, is the appearance of a discount to net asset value in the share price. Clearly, this cannot happen in an open-ended fund but in a closed-end fund it reflects an excess of sellers over buyers and it makes the share price somewhat more volatile than the net asset value. For existing investors, a widening discount is a problem, at least in the short term, as it constitutes a drag on the share price. For boards, it may represent an opportunity to enhance performance by buying in shares cheaply, and for new investors, an opportunity to buy the shares cheaply.
However, investors should regard a sizable discount as enhancing the case for purchase but not the main reason for purchase. Maybe the fund, the sector or the market is currently unpopular but will soon bounce back, with the discount disappearing again, but maybe the discount reflects structural issues which cannot be easily addressed. Many good investment trusts habitually trade at a premium but are still worth buying, while discounts will not necessarily narrow if performance is good. That said, there is a long-term trend towards narrowing discounts so that the sector average is now only 2%.
Getting access to information and good research is becoming less of a problem for private investors. Reports and accounts, interim reports and monthly fact sheets are usually available on websites and these contain details of past performance. Click the professional investor/financial adviser tab on the website rather than the private individual one as the latter gives access to much less information. Comparative information on investment companies is available on the AIC website, together with helpful information on them generally and links to research notes. These have usually been sponsored and paid for by the companies so are not independent but they are a good source of information – and it’s in nobody’s interest for the writers of them to be less than honest.
Many funds and management companies go to considerable length and expense in marketing, providing updates from the manager, podcasts, links to media coverage and easy access to statutory information. There is some very good coverage in the financial press – including, I hope, my own modest contributions in MoneyWeek. Finally, it is always worth turning up to annual general meetings, even if you can’t vote in person. These almost invariably include a presentation by the manager and an opportunity to ask questions either in public or face-to- face afterwards.
Time, however, is not necessarily on the investor’s side. Opportunities can be fleeting so there is little time for homework. Waiting for a setback in the share price or the market or for any discount to asset value to widen is nearly always a mug’s game. Remember the response of Nathan Rothschild when asked the secret of his success: “I never buy at the low and I always sell too soon.” Expect the share price to dip after your purchase and be pleasantly surprised if it doesn’t.
As important as picking good funds is putting together a coherent portfolio. This should include core generalist funds as well as specialist thematic funds. It makes sense to invest in technology, smaller companies, emerging markets and so on but not to have too much in any one niche. It’s good to have a reasonable level of income but this usually involves some sacrifice of total return. A bird in the hand is more highly valued than two in the bush but you may prefer the latter.
Investing in cheap trusts on wide discounts or in unpopular, undervalued areas of the market can be lucrative but be careful; ‘reassuringly expensive’ trusts often perform much better than ones that are visibly cheap. Everyone loves a bargain but real value is reflected in long-term prospects while wide discounts reflect serious trouble as often as investor short-sightedness.
The most difficult question of all is when to sell. As Warren Buffett said, “My favourite holding period is forever.” You don’t need to sell or take some profit in good investments unless you need the cash. I still hold the shares I bought on the flotation of WORLDWIDE HEALTHCARE TRUST at launch in 1995, and have only added to the holding along the way. I was sorely tempted to sell out of BLACKROCK WORLD MINING a few years ago but the share price doubled in the next year. I missed selling out of POLAR CAPITAL TECHNOLOGY in 2000, but can’t be sure I would have bought it back lower down.
Many investment sages point out that nobody ever went bust taking a profit. True; they went bust selling winners and reinvesting in losers. Sell if the investment thesis changes or you have made a mistake but don’t assume that the departure of a good manager is your cue for an exit. The directors are not fools and will be rigorously looking for a worthy replacement. But isn’t the stock market heading for another meltdown? Isn’t this the time to hold cash and wait for the bargains that litter the bottom of a bear market? The Jeremiahs worry that the economic up-cycle and the bull market have continued for longer than normal and must surely die of old age. At the start of 2018, many pundits predicted that the technology sector and the US market would suffer a setback as the rest of the world caught up. In fact, the reverse happened with the technology sector pushing historic US outperformance ever higher.
As always, there are reasons for concern. Monetary policy is being progressively tightened, especially in the US, and bond yields are pushing remorselessly higher. Emerging economies have, at best, hit bumps in the road, at worst are in crisis. Growth in the eurozone has fizzled out and the political tremors are worsening. The UK looks committed to a bungled Brexit. Against this, the signs of euphoria and complacency which normally mark market peaks are conspicuously absent.
Valuations, barely 16 times forward earnings in the US and lower elsewhere, are not stretched by historic standards and look cheap relative to cash or government bonds. There is no sign of the recession which would send earnings tumbling in the US, Europe or almost anywhere else. After the first decade of the new millennium saw two of the four worst equity bear markets in 100 years, caution and nervousness still prevail. A setback, as seen earlier in 2018, is always possible but more than that looks unlikely.
Geopolitical concerns abound but their impact on markets is highly uncertain. Though the long bull market in government bonds is surely over, the constraints on banks that prevent another credit boom and consequent bust look unlikely to be lifted. This should keep inflation and interest rates moderate by historic if not recent standards. Waiting for a better long-term buying opportunity could mean missing years of steady returns with little bank interest to compensate. Nick Train, manager of FINSBURY GROWTH TRUST, likes to tell investors each year that he is bullish; he points out that markets rise in three years out of four so that is the smart way to bet. Even if next year turns out to be the one in four, don’t panic. Buying at the high is not the biggest mistake an investor can make – selling at the low is. In time, markets recover and setbacks become barely visible interruptions of the long trend upwards.
MAX KING was an investment manager and strategist at Finsbury Asset Management, J O Hambro and Investec Asset Management. He is now an independent writer, with a regular column in MoneyWeek, and an adviser with a special interest in investment companies. He is a non-executive director of three trusts.
Would Brexit really rattle markets?
Ever since March when the pound dropped some 5% against the dollar and the euro, it has been the accepted wisdom that “Brexit” would be a negative for financial markets. That drop alerted investors to the reality of the looming UK referendum on remaining in the EU and the topic has featured high on investors’ worry list ever since.
The investment banks were quick to publish dire predictions about the economic consequences of Brexit soon followed by the Treasury, who claimed that it would cost the average household the equivalent of £4,300 a year by 2030. This then led them to predict that popular realisation of the long term consequences of Brexit would so affect behaviour as to cause a short term recession. International financial and economic organisations added their warnings but the argument is far from settled.
There has been no shortage of independent economists and former Chancellors of the Exchequer with views ranging from that Brexit would make little difference to those claiming it would be of significant log term benefit to the UK. The intuitively most sensible view has come from the highly respected Roger Bootle and his team at Capital Economics who argue that whether it turns out to be a plus or a minus depends very much on how the UK government manages any exit.
The market predictions have been equally lurid. BlackRock, guided by Rupert Harrison, a former chief of staff to the current chancellor, warned of a sell off in the pound, UK equities and UK property. Bank of America predicts that it would trigger a 15% drop in European, including UK, equities with currency weakness extending that fall to 20% for European equities and 25% for UK equities. UBS Wealth warns that FTSE 100 could fall 10% over the next year despite an 8% boost to corporate earnings from the pound falling to $1.25 and 1.2 Euros but rise 5% if the UK votes to remain.
The evidence from markets as opposed to from experts is much less convincing. It shows that a lot of risk is already priced in, implying that there is little downside whatever the outcome of the vote. In April, sentiment towards sterling, based on the pricing of currency options, reached the lows last seen at the height of the financial crisis in 2008. JP Morgan’s “Brexit basket” of UK stocks deemed most at risk had under-performed the FTSE100 by nearly since December. Further downside looked limited.
So it has proved. Sterling dipped below $1.40 in March, probably driven as much by the realities of a mounting current account deficit as by Brexit worries, but then recovered. When the opinion polls appeared to swing back towards Brexit in early June, sterling dipped to $1.44, then bounced. The direction of sterling appears highly correlated to the ebb and flow of the polls but the magnitude of the moves, despite lurid media headlines, has been modest. The FTSE 100 is trading about 10% above the February low, lagging the US market, as it has persistently for the last 25 years or more, but not obviously moved by political sentiment.
This should not be surprising. About two thirds of the profits of FTSE 100 companies are derived from overseas so any fall in sterling boosts the sterling translation of overseas profits, as UBS Wealth concedes, and gives a competitive advantage to exporters. Brexit may or may not have a negative long term economic impact on the UK but, even if it does, the implication for UK profits is less obvious. Business surveys show that larger companies, as represented by the FTSE 100, are much more concerned than medium sized or smaller companies or those that are unlisted. So companies more dependent on the UK economy are actually less concerned about Brexit than larger ones who appear well insulated from any impact on the UK economy.
No historical parallel is totally reliable but 1992 provides some interesting lessons. In the run-up to the May election, investors fretted about the likely election of a Labour government led by Neil Kinnock, as was confidently predicted by opinion polls right up till polling day. From late morning of election day, the market started to rally and by early afternoon, many hours before the polls had closed, the stock market was correctly predicting a Conservative victory. The markets jumped on the news but fell back the next week when the reality of endless recession sunk in; sterling was stuck in the Exchange Rate Mechanism which required prohibitively high interest rates.
When sterling was forced off the ERM that Autumn, equities soared, interest rates fell and the economy started to recover against the prediction of nearly every economist and investment sage. The lesson for 2016? If the vote is for “remain,” equities and sterling may fail to rally sustainably as investors switch their focus to other issues. If the vote is for “leave,” the strength of a consensus of official experts does not guarantee that it is right.
Investors and businesses are holding back from investment decisions in the belief that the outlook will be clearer after June 23rd. It won’t be. The best investment decisions are usually made when risk appears to be highest and therefore priced in. Waiting to charge in or out with the herd almost never pays off. Place your investment bets now and then sit back and enjoy the humiliation of all those experts after June 23rd; their humiliation if the vote is for “leave” and their disappointment if it is for “remain.”
Max King has been an investment manager for 30 years, the last 11 of which have been at Investec Asset Management.