With the outcome of Brexit still largely unknown, it has never been more important to understand the level of exposure to the UK domestic economy. While Investment Association sector definitions dictate that UK equity funds are required to have at least 80% of total assets invested in UK-listed companies. There are, however, no limits on where their revenues originate.
It is only by digging into a portfolio and gaining an understanding of the regions where companies' source their revenues that a more comprehensive picture can be drawn. Using Morningstar's new Revenue Exposure by Region metric, we compared funds found in the UK equity income, UK large-cap equity, and UK flex-cap equity Morningstar Categories with the FTSE All Share Index. This enabled us to identify how UK equity funds are positioned to give an indication of their convictions and offer a view on how they are placed to cope with different Brexit outcomes.
The Revenue Exposure by Region metric shows a fund's geographic exposure based on the revenue sources of the companies in its portfolio. The geographic revenue data at the company level is collected from filings and is aggregated according to a Morningstar proprietary methodology.
It is no secret that many UK companies, in particular the largest 100, derive a significant portion of their revenues from abroad. The FTSE All Share's UK revenue exposure was indeed only 27.7% – as of February 2019 – meaning over 70% of the revenues earned by its constituents came from outside the UK. Looking at funds across all three categories collectively, we found that the average UK revenue exposure stood at 37.5%, with 85% of funds having a higher revenue exposure to the UK domestic market than the index.
Our data set goes back to September 2018 and, since then, the average UK revenue exposure has increased but only by a marginal 65 basis points. Generally, funds had already positioned their portfolios regarding their UK outlook, although there were some funds that significantly repositioned their portfolios over that period. JPM UK Dynamic reduced its UK revenue exposure by 10.2 percentage points to 30.2%, while Aviva Investors UK Listed Equity Unconstrained increased its exposure by 10.3 percentage points to 38.3%.
Size Matters
Funds in the large-cap equity category were, on average, more exposed to UK revenues than the index but to a smaller extent. This variation can be partly explained by the average market cap of the funds, as large companies tend to earn more revenue from abroad.
Currency Matters
With over 70% of FTSE All Share revenues deriving from overseas, the relative performance of sterling can have a meaningful impact on constituents' share prices. A weaker sterling typically benefits companies whose revenues and dividends are paid in non-sterling. Our data set does not go back far enough to demonstrate it, but we would expect the relative performance of funds with a greater UK revenue exposure than the index to be positively correlated to the strength of sterling and vice versa.
Domestic Believers and Doubters
At the individual fund level, we identified those funds with the highest and lowest UK revenue exposure in each category. With over 70% of its revenues deriving from the UK, Omnis Income & Growth is highest in the UK flex-cap category. This fund is managed by Neil Woodford, a manager who first turned strongly bullish on the UK domestic market back in second-quarter 2017. At the other end of the scale was Neptune Income, which had 17% exposure to the UK. The fund's manager, CEO and founder of Neptune, Robin Geffen, did not favour his home market. This was confirmed by a similarly low revenue exposure in his other UK fund, Neptune Quarterly Income (21.8%).
Those with the highest UK revenue exposure included Bronze-rated Woodford Equity Income, managed by Neil Woodford – using the same approach as on Omnis Income & Growth – and Bronze-rated Invesco Income UK, Invesco UK Strategic Income, and Invesco High Income UK, all managed by Mark Barnett. Given that Woodford and Barnett are former colleagues with a similar contrarian, value-based approach to managing money, it is perhaps no surprise that they have similar positioning. Bronze-rated Liontrust UK Growth had the lowest UK revenue exposure of our rated funds. Managers Anthony Cross and Julian Fosh tend to focus on companies with wide economic moats and sustainable growth, which has seen them include bigger multinational companies with global revenue exposures.
Companies with the majority of their revenues deriving from the UK have significantly underperformed their more globally facing counterparts since the EU referendum in 2016. This has reflected the market's dislike of uncertainty and, arguably, its attempt to price in the impact of a disorderly no-deal Brexit (considered by the market as the worst-case scenario).
While there are a number of potential Brexit outcomes, for simplicity, we consider the two extreme scenarios and their implications:
- Hard/Disorderly No-Deal Brexit: Assuming that this scenario results in a further depreciation of sterling and a considerable economic downturn in the UK economy, funds with a lower UK revenue exposure relative to the index and peers would likely benefit from a tailwind.
- Soft Brexit/Remain: Assuming a soft Brexit, or the unlikely event of the UK remaining, results in sterling appreciation and a more benign environment for UK businesses, we expect funds with a higher UK revenue exposure relative to the index and peers to experience tailwinds and have a greater chance of outperformance.
The Risks of a Disorderly Brexit
Based on how domestically facing companies have performed since the referendum, we expect the level of a fund's UK revenue exposure to have a meaningful impact on future relative returns. With most active UK equity funds overweight UK revenue exposure relative to the FTSE All Share, we would expect the average fund to face performance headwinds relative to the index in light of a disorderly Brexit and vice versa. However, it is important to remember that this is only one factor among many to ruminate when considering active UK equity funds. Further, we have no real visibility on what the impact of each outcome will be – for example, a disorderly Brexit could result in significant fiscal stimulus to support and boost the economy – nor exactly how much bad news the market has already factored in. Ultimately, our findings should serve as a reminder of the importance of understanding to what, or to where, you are exposed when investing in a fund.
