How to Invest During Brexit? Look Outside the U.K., Fund Managers Say

British investors are weeks away from a potentially devastating shock. They may have little to do with fisheries or food standards, but the market they trade from could face headwinds if the U.K. fails to secure a trade deal with the European Union.

The pound could plummet. The country’s recession — its worst in over a century — could deepen. Even if Britain and the EU strike an agreement, asset managers say economic conditions in the U.K. could still worsen and uncertainty is unlikely to vanish overnight as the specifics of the pact are thrashed out.

That would all come on top of an already dour year. U.K. assets have lagged most of their developed market peers in 2020. While Brexit uncertainty hurts stocks on both sides of the channel, the FTSE 100 Index’s 23% slide this year is deeper than the 14% decline in the STOXX Europe 600 Index.

Meanwhile, the S&P 500 Index of U.S. equities climbed about 7% and MSCI’s global stock gauge rose 3% in 2020 through the end of last week. U.K. government bonds, which normally should fare well during periods of uncertainty, have also underperformed on fears that Brexit will push inflation higher. Gilts were down 1.3% in the third quarter while American Treasuries and German bunds advanced.

Faced with the prospect of deeper losses, many British investors have begun to look abroad.

But at a time of global turmoil, where should they even begin? To find out potential opportunities and hurdles, we spoke with London-based chief investment officers from BlueBay Asset Management, Barclays Plc, Arbuthnot Latham and Kingswood Group, whose clients range from the very wealthy to mom-and-pop investors.

The Down Pound

The first snag Brits may face is the country’s weakened currency. Sterling has fallen about 5% versus its major trading partners this year, making it more expensive to buy overseas assets.

But for William Hobbs, chief investment officer of Barclays’ wealth management arm, the benefit of paying the price to buy into markets outside Britain is well worth the cost.

Pound-denominated exchange traded funds that track markets abroad can help mitigate currency volatility, according to Bloomberg Intelligence analyst Athanasios Psarofagis.

Bloomberg Intelligence tracks country-focused ETFs listed in Europe and the U.K., and two in particular saw large inflows and heightened returns in the third quarter. One is the iShares MSCI China A fund, which tracks an index of China’s largest and most liquid companies. Its pound-denominated version has given local investors a 26% total return this year, according to data compiled by Bloomberg. Meanwhile, the Invesco EQQQ Nasdaq-100, which replicates the U.S. tech index’s performance, has returned 34%.

Returns like these would make up for the British currency’s loss against its major peers by far.

“The story is: Diversify now,” Hobbs said.

Global Destinations

The easiest way for local investors to get offshore exposure is to invest through global funds or ETFs, according to several fund managers.

At the moment, European stocks look cheap and come with less Brexit exposure than their U.K. counterparts, said Mark Dowding, CIO at BlueBay Asset Management, which manages about $60 billion. That is because as a percentage, Britain’s trade with the EU is higher than the EU’s with Britain, so European companies are less likely to face direct negative consequences from a failed Brexit deal.

Dowding recommends investing in European bank debt. Yields on their contingent convertible bonds of around 4.5% have been very attractive. Because banks are now very well capitalized and conservatively managed “they are much less exposed to the threat of recession than was the case in 2008,” he said.

Gregory Perdon, CIO at Arbuthnot, which oversees 1.1 billion pounds, cites Japan and China as countries offering higher returns on investors’ capital. Japan has growth stocks, which tend to be tech companies, while China has been notable for its ability to recover from the economic impact of lockdowns earlier this year.

“China is pulling a rabbit out of a hat,” Perdon said. “It nailed a V-shaped recovery.”

Among Japan-focused funds listed in Europe and the U.K. tracked by Bloomberg Intelligence, the Lyxor Core MSCI Japan (DR) ETF saw some of the biggest inflows last quarter — 120 million euros. The U.K. version of the fund has returned 2% this year, data compiled by Bloomberg show.

Sector Selection

That said, wealth managers do not recommend indiscriminate offshoring, particularly at a moment of uncertainty across the globe.

“It’s important to get sector allocation right,” said Rupert Thompson, CIO at Kingswood Group, which manages 4.8 billion pounds. “That’s probably at least as important as the regional exposure.”

His firm allocates around 25% of its equity exposure to a selection of favored themes or sectors and the rest on a regional basis. “But our regional positions are also driven in part by the sector weightings of the various regions,” he said.

Although 75% of FTSE 100 companies’ earnings come from overseas, the index still lagged its U.S. counterparts this year because it has fewer technology names, Thompson said. In addition to tech, he favors stocks related to health care and climate change. His firm, for instance, invests in Pictet Global Environmental Opportunities, which is involved in sectors such as pollution control, energy efficiency and recycling.

In Search of British Gems

The good news is, it’s not all doom and gloom in the U.K. — investors just have to look far enough into the future.

Tech is a bright spot, according to many investors, with the startup space booming. As of end-2019, the U.K. had 77 startups valued at more than $1 billion. That’s more than double that of Germany, the next biggest, according to data provider Dealroom.

At the moment, private equity and venture capital firms are the biggest players in this area. But more individual investors seeking exposure to startups are investing using venture investment platforms such as Seedrs and Crowdcube. In essence, these firms allow individuals to crowdfund young companies.

Another sector that is performing well is the housing market, according to Arbuthnot’s Perdon. Ever since the government unveiled a property tax break in the summer — and as Brits gear up for more days working from home — asking prices for houses nationwide have picked up significantly.

But don’t take this as a push to finally splash out on a dream home. “Investing in residential property is a tricky one,” Perdon said. “Often one’s primary residence equates to such a large portion of the family’s net worth that any residential investments quickly transforms into a ‘double overweight’.” An investor whose investment in a primary residence fails loses not just money, but also his or her home.

Instead, Perdon sees house-building stocks as a good way to get into real estate if the market stays up.

Perdon, who is French, said he has enough reason to be optimistic about the U.K.’s long-term prospects that he’s even applying for British citizenship.

“In the short term, it’s very difficult to make a bullish case for U.K. assets,” he said. “But longer term, I am bullish Britain.”

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