Since the SIM Global Equity Income Fund has a large exposure to UK-listed shares, we often get asked about the effect of Brexit on the fund’s returns and positioning. The short answer is that Brexit is unlikely to have a significant negative impact on the fund’s long-term performance. In this article, we explain why we believe this is the case by taking an in-depth look at the market developments since the initial shock vote in June 2016 and the nature of the fund’s UK holdings.
UK-listed shares have contributed to the SIM Global Equity Income Fund’s exceptional performance over the years.
The objective of the SIM Global Equity Income Fund is to provide a targeted and growing stream of income derived from dividends, in addition to real capital growth. The fund has a relatively large exposure to UK-listed shares (37.1% at 31 August 2017), mainly because of these shares’ attractive dividend yields and the favourable tax treatment of these dividends. However, this figure significantly exaggerates the fund’s true economic exposure to the UK (as explained later in this article). As shown in Figure 1, the fund has consistently outperformed its benchmark since its inception in 2012.
Figure 1: SIM Global Equity Income Fund – annualised performance as at 31 August 2017*
Sources: Denker Capital, Morningstar
*Notes: Performance figures are for the A class of the fund, the highest fee class available to retail investors, which has an annual management fee of 1.25% (excl. VAT) and distributes income bi-annually. These figures are annualised, net of fees and in US dollar terms. The benchmark of the fund is a composite index of the US Consumer Price Index plus the MSCI World High Dividend Yield Index.
The aftermath of the Brexit vote – the market’s response versus the impact on the fund.
The market’s response showed that UK-based companies would be most affected.
The announcement of the UK’s decision to leave the European Union (EU) on Friday 24 June 2016 took the market by surprise. The overwhelming sentiment was that it would have a negative impact on the UK economy and corporate sector. On the day of the announcement, the British pound dropped significantly and the UK stock market tanked. After the market had a weekend to absorb the news, the currency and stock market retreated even further on the Monday. In total, the pound lost 11.2% versus the US dollar, the MSCI UK Index dropped 16.1%, and the MSCI UK Small Mid Index lost 23.5% (measured in US dollars). This was a brutal adjustment indeed.
These market movements implied two key points:
- The aggregate value of the UK had dropped by roughly 10% (implied by the impact on the pound).
- The impact on UK-based companies was expected to be far greater than the impact on companies that are only domiciled in the UK. This is evident from the much greater fall in the MSCI UK Small Mid Index, which is dominated by UK-based companies, compared to the MSCI UK Index, which consists predominantly of large multinational companies. It’s also important to consider that the MSCI UK Small Mid Index is a constituent of the MSCI UK Index, which means its fall was responsible for a considerable part of the aggregate index’s fall.
After five weeks considering the implications of the Brexit vote, a significant amount of the initial losses was restored by the market, despite a lack of recovery in the currency (as shown in Figure 2). By 29 July, the MSCI UK Index and the MSCI UK Small Mid Index were down 4.7% and 9.9% respectively compared to the day before the announcement (in US dollars). The pound was down by 10.3% versus the dollar.
Although the fund suffered an initial loss, its recovery over the next month was remarkable.
At the time of the Brexit vote, the SIM Global Equity Income Fund had a relatively large exposure to UK-listed shares (38.7% of the portfolio). As a result, the fund was caught in the turmoil and suffered a loss of 6.5% on the day of the announcement and a further loss on the following Monday, taking the total loss to 10.0%. In reaction, we reassessed each of the positions in the fund as objectively as possible. We concluded that the market had overreacted and, rather than getting caught up in the panic, we selectively added to some of our positions at their post-Brexit prices. By the end of July 2016, the fund’s loss was down to only 2.1%.
Considering that the outcome of the Brexit vote was unexpected and is likely to have a profound effect on the UK’s trade relationships, it was probably one of the most severe stress tests the SIM Global Equity Income Fund could have faced. The fact that, a month after the event, the fund had sustained a loss of only 2.1% is testament to the resilience of the fund.
Figure 2: The market and fund movements following the Brexit vote compared to the day before the announcement
Sources: FactSet, Denker Capital
*Notes: These figures are for the A class of the fund and are calculated using the unit prices of the fund net of fees and in US dollar terms.
A year after the Brexit vote – how the fund is currently positioned.
The SIM Global Equity Income Fund derives only a limited amount of its revenue from the UK.
It is essential to point out that the bulk of the fund’s exposure to UK-listed shares is to multinational companies that simply choose to base their headquarters in the UK. In most cases, they derive only a small percentage of their profits from the UK. This means that the true extent of the fund’s actual exposure to the UK is (and was) far smaller than it appears.
Figure 3 shows the aggregate regional contributions to the revenue of the fund by the companies in the portfolio as at 31 August 2017. This highlights some important facts:
- If the SIM Global Equity Income Fund was a single company, only 13.3% of its total revenue would be generated in the UK. While this is substantially more than the MSCI World Index’s UK exposure of 5.6%, it is not nearly as high as suggested by the fund’s 37.1% exposure to UK-listed companies. (Although the MSCI World Index is not the fund’s benchmark, it is a useful reference.)
- The fund’s 37.1% exposure to UK-listed shares translates into only an 11.2% revenue exposure to the UK.
- Although not shown in the figure, only five companies, representing 11.4% of the portfolio, derive more than 25.0% of their revenue from the UK.
- Relative to the MSCI World Index, the SIM Global Equity Income Fund is somewhat underexposed to developed markets in terms of its revenue sources (75.6% versus 82.4%) and overexposed to emerging markets (21.5% versus 17.6%). This positioning is the result of our bottom-up share selection process – it is not a target we consciously aim to meet. However, as part of our ongoing risk management, we would be uncomfortable if this analysis revealed an excessive concentration in any one region.
Figure 3: Breakdown of the regional contributions to the SIM Global Equity Income Fund’s total revenue (at 31 August 2017)
Source: FactSet GeoRev
Note: The revenue contribution is used as a proxy for regional exposure, because sufficient data is not available to do such an analysis on profits.
Our investors have been rewarded by our selective additions to the fund’s UK-centric positions.
As mentioned above, when considering the fund’s exposure to the UK, we make a distinction between companies that derive the bulk of their revenue from the UK (UK-centric) and those that are more global in nature (non UK-centric).
Figure 4 shows the severe drop in the share prices of some of the UK-centric companies in which the fund invests in the days following the Brexit vote, and how they recovered almost all their losses in the subsequent months. These recoveries were due to the market’s reassessment of the potential effect of Brexit on the future performance of the companies, as well as the reported business performance of the individual companies after the vote.
Figure 4: Total return of UK-centric shares for the period 1 January 2016 to 31 July 2017 (in US dollars, indexed)
Sources: FactSet, Denker Capital
These performance figures show how investors in the SIM Global Equity Income Fund have been rewarded by our decision not to sell in the wake of the Brexit vote. Instead of getting caught up the in the emotional reaction from the market, we stayed calm and rather selectively added to some of these positions. We remain convinced that there are good reasons to continue holding these shares. However, we will constantly re-evaluate our ongoing investment in these companies.
Figure 5 illustrates that the share prices of the non UK-centric companies in the portfolio were far less affected by the Brexit vote. It has largely been a case of business as usual. The slight volatility in their share prices can be attributed to factors other than Brexit. For these shares, we will continue to follow our standard risk management process through ongoing performance monitoring and evaluation.
Figure 5: Total return of non UK-centric shares for the period 1 January 2016 to 31 July 2017 (in US dollars, indexed)
Sources: FactSet, Denker Capital
Going forward – the Brexit negotiations should not pose significant risks to the fund.
Future developments associated with Brexit are unlikely to result in similar market turmoil.
The significant currency and share price weakness that followed the Brexit vote announcement can largely be attributed to the fact that the outcome was unexpected. The market was not prepared for the result and what it meant, and shock and fear kicked in. With more than a year having passed, the market has had ample time to assess the likely outcomes of the Brexit process and we believe these are now adequately reflected in current share prices.
Even if the ongoing Brexit negotiations become adversarial, resulting in further episodes of share price volatility, this will unlikely be on the same scale we saw in June 2016. The biggest shock is over and whatever follows is probably not going to have the same impact.
The fund’s level of risk connected to the UK is not as big as it seems.
As explained earlier, the bulk of the fund’s exposure to UK-listed companies involves multinational companies that derive only a small percentage of their profits from the UK. As a result, only 13.3% of the fund’s revenue is in fact generated from the UK. This means that the fund’s exposure to developments in the UK economy is far smaller than is implied by its relatively high exposure to UK-listed shares.
Navigating unexpected macroeconomic events such as Brexit – the value of our investment process
Unexpected macroeconomic events will always haunt the market and trigger radical reactions
Unexpected macroeconomic events such as Brexit are nothing new. They have and will continue to catch the markets off guard. To be able to make prudent investment decisions at these times, it’s important to understand how and why the markets react the way they do when these surprises happen:
- Markets thrive on predictability and despise nasty surprises
That is why central banks are always careful to communicate their intentions as clearly as possible. It is also why developed markets tend to trade at higher multiples than the less predictable emerging markets.
- Markets react brutally and quickly to unexpected news
This happens whether it is macroeconomic news or specific to a company or industry. In the event of a negative surprise, prices most often discount the worst-case scenario within minutes, and then gradually find a new equilibrium as markets digest the news. This process seldom takes more than a few days.
- In the short term, markets tend to overreact
Macroeconomic events generally have a far less significant impact on the performance of a company’s medium- to long-term fundamentals than is generally assumed. This is because well-managed companies with quality products are almost always able to adapt to changes in the operating environment through a combination of innovation and reorganisation.
Our disciplined investment process helps us focus on the long term, despite short-term market turmoil
For these reasons, we will continue to apply our proven investment process when making investment decisions for the SIM Global Equity Income Fund, whatever happens in the economy and the market. We manage the fund with a three- to five-year investment horizon and are aware that unexpected events can cause short-term market volatility. However, these seldom have a significant impact on the fund’s long-term performance and often present an exploitable opportunity. We will continue to focus on objective stock valuations, based on in-depth research, and not allow emotions to influence our decisions.
Portfolio manager: SIM Global Equity Income Fund
Co-portfolio manager: Sanlam Global Best Ideas Fund
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