What would a hard Brexit mean for passive investing?
“What will happen to the pound if we leave Europe with no deal?”
Asset Managers across the globe have put contingency planning into place for the possibility of a so-called ‘hard Brexit’, with playbooks produced explaining the likely effects on asset prices, and how asset allocations could be changed to mitigate these moves.
Although we have also undertaken similar analysis here at AJ Bell, we believe a hard Brexit presents other potential issues, especially pertinent to passive investing, that may have been overlooked by many. First though, we will address how we will navigate turbulent markets within our passive products.
Index trackers are, by design, exposed to systematic risks such as large currency moves, a change in interest rates or an increase in uncertainty (often approximated by market volatility). Therefore, when investing in passive vehicles you are fully exposed to these moves because, unlike an active fund manager, you cannot move into securities that are not part of the benchmark, or even into cash within the fund.
Although the AJ Bell Passive funds and MPS are passive in name, this merely refers to the type of securities invested in, and not the approach to asset allocation. In the event of a hard Brexit we would expect the markets’ reaction to be similar to that seen after the referendum result which, counterintuitively, led to gains for most UK-based investors with a diversified international portfolio. For example, a fall in the pound would lead to underperformance in UK-based holdings such as the Vanguard FTSE 250 ETF, and outperformance in international trackers such as the iShares US Technology ETF. If the pound fell, any investments in other currencies would be worth relatively more in pound sterling terms.
The passive vehicle itself is often overlooked, and in normal market conditions this is not an issue – the fund or ETF provides daily (or intraday) trading and the price of the vehicle closely tracks the price of the underlying securities. A hard Brexit would not represent normal market conditions, and therefore it is important to consider not just the underlying investments, but the liquidity and price of the passive vehicle.
23 June 2016 provided a preview of some of the difficulties that may be faced in the event of a hard Brexit, namely the decision by many active UK property funds to suspend redemptions. Despite offering daily dealing, it was a reminder that a fund is only as liquid as the underlying investments – as managers had to sell illiquid properties to raise cash to fund the redemptions, they were left with no choice but to suspend dealing whilst raising the necessary capital.
Passive investments usually take one of two forms; either on open-ended tracker fund or an ETF, which has characteristics of both an open-ended and closed-ended fund.
So what do we mean by open- and closed-ended?
An open-ended fund has no fixed size, growing or shrinking due to investor demand. Open-ended funds usually offer daily dealing, which means an investor can withdraw their money at short notice. In order to satisfy the redemption the fund manager must sell-down assets to raise cash as previously described. If the fund manager is unable to sell sufficient assets then redemptions can be suspended. On the other hand a closed-ended fund has a fixed size, with investors buying and selling investments in the fund between them, rather than interacting directly with the fund; analogous with buying or selling shares in a public company. The advantage of this structure is that the liquidity of the fund is independent of the liquidity of the underlying investment, and it can continue to trade on a daily basis.
However, the consequence of this is that the closed-ended fund may trade at a price above or below the value of the underlying investments (known as a premium or discount), driven by investor demand. The structure of an ETF means this should remain within a narrow band, and even though this may widen during times of market stress, the fund is still available to trade. We believe ETFs are the ideal structure for dealing with any potential liquidity crunch through a hard Brexit; they act as open-ended funds, offering subscriptions and redemptions on a daily basis, but they also have the ability to trade as a closed-ended fund, providing an alternative trading mechanism in the event liquidity dries up.
Research produced by Vanguard in February 2018 shows that for US-based equity ETFs (where statistics are more readily available), the majority of trading is between investors rather than directly between an investor and the ETF. For every $1 traded directly with the fund manager (primary market), $16 trades from one investor to another (secondary market). In the event of a liquidity crisis the ability to exit ETFs quickly by selling to another investor and with relative certainty (compared to the traditional open-ended fund), is one of the reasons we have used mainly ETFs in preference to index tracking funds in our Passive funds and MPS.
Split between primary and secondary trading volumes for US Equity ETFs, February 2018
The final area we have explored is the regulatory impact of a hard Brexit on passive vehicles. After undertaking several conversations with passive managers we believe there are two key areas for consideration:
- Where is the product domiciled?
- Is it tradable on a UK stock exchange?
Tracker (and indeed active) funds tend to be based in either the UK or Europe (Ireland and Luxembourg). For UK-based funds a hard Brexit should not present any additional issues, however any non-UK-based fund, such as Irish UCITs funds, will not automatically remain available for UK investors as they will not fall under the FCA’s jurisdiction.
Announcements made to date by the FCA indicate temporary permissions would be put into place to allow existing funds to be held and traded after Brexit for a period of time. However it would create a cloud of uncertainty. It is likely that fund groups will look to set up UK- domiciled vehicles and transfer investors across, which could incur costs for both the fund group and the underlying investor, depending on the mechanism used (such as a scheme of arrangement).
Only a small portion of our passive products are invested in tracker funds, and the ones we do hold are all domiciled in the UK. We hold an investment in a money market fund domiciled in Ireland, but in the event of a hard Brexit we would be able to sell it down and hold cash instead. The AJ Bell Passive funds are domiciled in the UK, so would have no issues here.
ETFs are very rarely domiciled in the UK, however all our investments are in ETFs listed on the London Stock Exchange. Although the underlying fund may have to consider any regulatory effects due to not being domiciled in the UK, we will be able to continue to buy and sell our holdings through the secondary market, trading on the LSE.
So what would a hard Brexit mean for passive investing?
In one word, uncertainty. However, we believe that by investing in ETFs rather than index trackers the potential pitfalls are reduced, and although no-one knows what the UK’s relationship will look like come March 2019, the ability to trade quickly between different products allows us to react to any eventuality.