UK equity income funds were among funds with the greatest correlation to companies deriving the largest portion of their income from the UK, according to research by FE Trustnet.
Last year’s referendum caused many investors to become more bearish about the prospects for the domestic economy.
Indeed, the lack of clarity around Brexit and the future relationship with the EU – the UK’s largest trading partner – has created much uncertainty for companies with broad exposure to the UK economy.
To try to measure the impact of the referendum result, index provider Bats – owned by the Chicago Board of Options & Exchanges (CBOE) – launched two Brexit-focused indices earlier this year.
The Brexit Low 50 and Brexit High 50 each contain 50 companies from the Bats UK 100 – which tracks the top 100 UK-listed stocks by market capitalisation – and split into those with the largest and smallest sterling revenues.
The Brexit High 50 is composed of the 50 companies with the largest exposure to sterling revenues and as such should have a bigger exposure to the domestic economy.
Conversely, the Brexit Low 50 is made up of the 50 companies with the smallest sterling revenues and thus should have a more international focus.
Launching the indices in March, Mark Hemsley, president of Europe for CBOE, said the Brexit indices were designed to “gauge investor sentiment towards UK companies”.
Performance of indices since EU referendum
Source: FE Analytics
Since the referendum the Bats Brexit High 50 index has returned 18.77 per cent while the Bats Brexit Low 50 index is up by 33.57 per cent, as the above chart shows. In comparison, the Bats UK 100 index is up by 28.92 per cent.
Below FE Trustnet has considered which funds have a high correlation to the Bats Brexit High 50 index and how they have performed since last year’s referendum. It should be noted, however, that none of the funds are benchmarked against the Brexit High 50 index.
To measure which funds have a high correlation to the index, FE Trustnet used the r-squared ratio, which indicates how closely correlated a fund is to an index. With more than one years’ data, FE Trustnet used the monthly return figures.
The sector with the highest average r-squared figure is IA UK Equity Income, although it is closely followed by the IA UK All Companies sector.
The average IA UK Equity Income sector has a r-squared ratio of 0.78, while the average IA UK All Companies fund has a ratio of 0.75.
According to FE Analytics, a figure upwards of 0.7 suggests a fund’s behaviour is closely linked to its benchmark.
Conversely, the average IA UK Smaller Companies sector fund has an r-squared ratio of 0.57. Following the referendum many investors fled the UK small-cap stocks, highlighting concerns over their exposure to the domestic economy.
Each of the UK equity fund sectors outperformed the Bats Brexit High 50 index, however, as the below chart shows.
Performance of sectors vs index since EU referendum
Source: FE Analytics
The best performing sector was IA UK Smaller Companies where the average fund delivered a 43.36 per cent gain in the between 24 June 2016 and 10 October 2017.
The average IA UK All Companies fund returned 29.58 per cent, while its peer in the IA UK Equity Income sector returned 25.05 per cent.
Delving further into the UK equity sectors, FE Trustnet was able to identify several funds with the greatest correlation to the Brexit index.
Indeed, the fund with the highest r-squared ratio relative to the Bats Brexit High 50 was the AXA Framlington Blue Chip Equity Income fund, which stood at 0.84.
The £94.2m AXA fund is managed by Jamie Forbes-Wilson and aims to produce a higher than average income with long-term growth of income and capital.
The IA UK Equity Income sector fund has more than two-thirds of its portfolio invested in the FTSE 100, with much of the remainder held in FTSE 250 stocks.
Writing in the fund's interim report last year Forbes-Wilson noted that its exposure to UK housebuilders, domestic banks, retailers and real estate companies had had a negative impact on performance immediately following the referendum result.
“The market’s knee-jerk reaction to the Brexit result was to sell first and to ask questions later,” he wrote. “Selling was focused on the more domestically-oriented names, which are principally found in the mid-cap FTSE 250 Index.
“International investors had already shied away from the UK market in the first quarter of 2016, but June saw further selling and the FTSE 250 Index fell 5.06 per cent.”
Since the referendum, the fund has returned 24.8 per cent.
Second-placed was the Royal London UK Growth fund with an r-squared ratio of 0.8. The £779.6m IA UK All Companies fund is managed by Richard Marwood and invests across the market cap spectrum.
While it does not offer a breakdown by market cap, the fund’s top 10 holdings are all FTSE 100 companies.
“The ongoing Brexit negotiations, UK and US political uncertainties and tensions around North Korean military aggression make economic predictions difficult,” wrote Marwood in his most recent factsheet. “The fund is not being positioned for any single macro-economic scenario, but is instead looking to invest in a range of companies that are in control of their own destinies, irrespective of market conditions.
“The fund aims to invest in businesses that have strong market positions, robust cashflows and appropriate balance sheets, all traits which typically indicate long-term dividend growth.”
The Royal London fund has returned 33.33 per cent since 24 June last year.
Several other funds also had high r-squared ratios of 0.79, including: Royal London UK Opportunities, Allianz UK Equity Income, Standard Life Investments UK Equity High Alpha, Castlefield B.E.S.T Income, and L&G Ethical Trust. According to data from FE Analytics, 74 UK equity funds had a r-squared ratio of 0.7 or more.
At the opposite end of the spectrum was Ardevora UK Equity fund, which had an r-squared ratio of 0.06. The £207.3m fund managed by FE Alpha Managers Jeremy Lang and William Pattisson had the lowest ratio of all the UK equity funds reviewed by FE Trustnet.
Lang and Pattisson employ a long/short strategy and looks for signs of bias in the market, concentrating instead on “observable facts” such as stock prices, valuations, forecasts, company accounts and analyst reports.
Of course, investors should note that its low r-squared ratio is the result of it being able to actively short stocks in the index.
Funds with a focus on companies toward the lower end of the market cap spectrum dominate at the bottom of the table.
The four FE Crown-rated CF Livingbridge UK Micro Cap fund managed by FE Alpha Manager Ken Wotton has one of the lowest r-squared ratios of the UK equity sector at 0.13. It has returned 40.1 per cent since last June.
It is joined at the bottom by the Neptune UK Mid Cap, overseen by FE Alpha Manager Mark Martin, and Richard Penny’s L&G UK Alpha Trust, both of which have r-squared ratios of less than 0.2.
In a separate article, FE Trustnet will consider the funds correlated to stocks with a lower exposure to the domestic earnings.