What Does Brexit Mean for UK Equity Funds?

The average flex-cap UK equity fund has more than half its portfolio in mid and small cap stocks - how will Brexit affect the performance of these funds?

Samuel Meakin 28 June, 2016 | 10:11AM
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UK equities took an immediate hit on Friday but the sector has been shaky since the beginning of the year, as investors fearful of a Brexit fallout shunned domestic stocks.

The average fund in the Morningstar UK Flex-Cap Category has more than half of its assets in mid-cap stocks

Although the medium- and longer-term economic effects of the British electorate’s decision to leave the European Union are far from certain yet, the reaction in UK markets in Friday’s aftermath provided some insight into investors’ immediate concerns.

The FTSE 100, after opening more than 8% down, staged a recovery throughout the day to finish only around 3% down at the close. It is worth noting that the index was up 2.4% over the week as a whole, however. The large companies that constitute this index have significant international earnings streams which, following the fall in sterling, are now worth more in UK domestic currency terms. Indeed, around 80% of the FTSE 100’s earnings come from overseas. This likely helped to provide support through the day, despite the precipitous falls in areas such as the banking stocks that make up part of the index, and backing was seen in areas like tobacco, for example, with both British American Tobacco (BATS) and Imperial Brands (IMB) posting gains on the day.

The story was different for the FTSE 250, however, which closed over 7% down, albeit an improvement on the initial 11% fall at the start of the day. The greater domestic focus of the companies in the mid-cap index meant that these stocks took more of the pain, with house builders particularly affected.

What Does this Mean for UK Equity Funds?

What does this mean for managers of mainstream UK equity funds, who have traditionally used allocations to mid-cap stocks as a source of potential capital appreciation? The average fund in the Morningstar UK Flex-Cap Equity Category has an allocation of more than half of its assets to stocks outside of the giant- and large-cap names. In recent years, the strong performance of the mid-cap segment of the market has thus helped a large number of UK equity managers to outperform.

The average fund in the category has outperformed the FTSE All-Share index by over 200 basis points on an annualised basis over the last five years. Nonetheless, the uncertain economic environment following the Brexit vote may give rise to a change in the market dynamics that have been favourable for the mid-cap stocks and the funds with large allocations to them.

Despite a large proportion of UK equity funds having overweight allocations to the mid-cap segment of the market, there are also a number of funds rated positively by Morningstar fund analysts that are more focused on the larger end of the scale. Several equity-income funds feature high up on this list, which is understandable: the ten largest dividend payers are all giant-cap companies and they pay out over 50% of the market’s total dividends. But outside of the equity-income universe, we can point to a number of funds that invest the vast majority of their assets in large-cap companies.

3 Funds Less Likely to Feel the Brunt of Brexit

Old Mutual UK Alpha is managed by the highly experienced Richard Buxton. He is a patient investor, taking a long-term approach to identifying undervalued companies and often incorporating a contrarian angle to his stock selection. This value style bias has been a headwind to performance over the past 18 months, but the fund has outperformed its benchmark and category average over Buxton’s tenure. The fund’s allocation to giant- and large-cap stocks stood at 72% as of 31 May 2016 and included names such as GlaxoSmithKline (GSK) and Royal Dutch Shell (RDSB). The fund has a Morningstar Analyst Rating of Silver.

Lindsell Train UK Equity, managed by Nick Train, looks to invest in high-quality franchises that can prosper through a number of business cycles. He takes a long-term outlook and portfolio turnover is therefore very low. The fund is unconstrained, so it can and does take large sector bets compared to peers, and the portfolio is concentrated, with around 25 holdings. It holds sizeable positions in a number of large companies including Unilever and Diageo. The fund’s allocation to giant- and large-cap stocks stood at 75% as of May 31 2016. The fund has a Morningstar Analyst Rating of Gold.

Royal London Sustainable Leaders, managed by Mike Fox, seeks to invest in companies that benefit society in terms of the products and services they provide, or companies that show leadership in environmental, social and governance management. The manager looks for businesses where longer-term growth prospects have been mispriced, and strong stock selection in recent years has helped the fund to outperform despite the allocation to large-cap stocks being higher than that of its average peer. The fund’s allocation to giant- and large-cap stocks stood at 77% as of 31 May 2016, including sizeable positions in stocks such as AstraZeneca and RELX. The fund has a Morningstar Analyst Rating of Bronze.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
British American Tobacco PLC3,033.00 GBP0.00Rating
Imperial Brands PLC1,732.00 GBP0.00Rating
LF Lindsell Train UK Equity Acc506.52 GBP-0.18Rating
Royal London Sustainable Leaders C Acc294.61 GBP0.51Rating

About Author

Samuel Meakin  is a fund analyst for Morningstar