by Jake Moeller.
As we trundle on in the aftermath of the “Brexit” result of the recent British EU membership referendum, the surprise, and perhaps shock for many analysts and investors has begun to be digested – the Earth remains constant on its axis and the sun still rises. This event however, undoubtedly presents challenges to the European and U.K. funds industry. However, despite the wringing of hands and the barrage of related press coverage, these challenges may not be as material as investors might expect.
Risk off in June & July no surprise
The initial reaction of investors has been, unsurprisingly, a knee-jerk of considerable risk aversion. According to Lipper data, the pan-European mutual fund market suffered net outflows of over €20 billion for June 2016. It saw massive net inflows into Dublin-based money market funds, with some €14 billion going into U.S. dollar-denominated funds and €6 billion into Sterling denominated funds. This came at the expense of European and global equities funds.
July reclaimed €22.0 billion of net inflows but risk aversion was still clearly evident with €13.3 billion flowing into Euro denominated money market funds (see Exhibit 1, below) and €5.3 billion flowing out of European equity funds (See Exhibit 2, below).
Exhibit 1. Top Ten Fund Sectors by net Inflows, July 2016 (Euro Billions)
Considering the rough market conditions during first half 2016, it was not surprising that the assets under management in the pan-European mutual fund industry decreased from the record level of €8.88 trillion (as at December 31, 2015) to €8.76 trillion at the end of June 2016. However, this decrease of €126.7 billion has been mainly driven by the performance of the underlying markets (-€156.2 billion), while net sales contributed net inflows of €29.5 billion to the overall change in assets under management in the European fund industry. A smaller net inflow compared to previous years, but still positive.
Exhibit 2. Top Ten Fund Sectors by net Outflows, July 2016 (Euro Billions)
Despite these flows figures, equity markets have been surprisingly buoyant. The MSCI AC World Index in Sterling has reached a five-year high (see Exhibit 4, below). Short-term fund volatility for U.K.-domiciled funds has returned to pre-vote levels after almost doubling immediately after the vote outcome (see Exhibit 5, below).
Flow disruption is par for the course
Of all the industries that have touch points to the ramifications of the Brexit outcome, the mutual funds industry is best placed to deal with such challenges. For U.K.-domiciled funds net outflows for June 2016 were nearly £3 billion, which might sound considerable. By contrast, in the China-induced summer wobble of last year the U.K. fund market suffered net outflows of £11 billion.
In the oil price shock of January and February 2016 net outflows were nearly £16 billion. Similarly, the recent short-term fund volatility spiked considerably last summer, only to return to a normalized level. The main difference with the Brexit induced volatility has been the marked increase in gilt volatility which is more unusual but this too has reduced.
Exhibit 3.European Fund Flows by Product Category (in €bn)
Fund houses constantly deal with such contrasting market dynamics–outflows in a rising market, inflows in a falling market, and all combinations in between. For 2008 the European fund market experienced nearly €600 billion of net outflows, but it collected some €200 billion net for 2009. The Greek crisis of 2011 resulted in €100 billion of net outflows, but over €200 billion net flowed in for 2012 (see Exhibit 3, above).
In any period of risk aversion, there are still asset allocation models which need to be populated. Discretionary fund managers in the UK are currently sitting on double-digit levels of cash. Their European counterparts are holding even higher levels. This cannot be justified for fee paying clients. This money will need to flow somewhere and it will require investors to carefully consider their next steps, but consider it they will. Whether it goes into equities, bonds or property, what has gone out, will have to come back in.
Fund houses are already inoculated
Certainly Brexit has caused consternation and reveals a considerable set of unknowns. However the global financial crisis of 2008 was considerably more material. It forged much of the change which means groups having survived that particular maelstrom, are now much better equipped to deal with a comparatively local event such as Brexit.
Exhibit 4. MSCI AC World Index over 5 Years (to Sep 13, 2016 in Sterling)
Consider what fund houses have had to endure in terms of the myriad legislative reforms since 2009. Direct acronym-heavy touch points include: MiFID II, AML, KYC, EMIR Shareholdings. Indirectly, add BASEL III, Solvency II, CRD, Dodd Frank, and AIFMD. According to our Risk & Regulatory Data Solutions, there were some 51,000 global regulatory updates in 2015 for groups to contend with. Then you can throw in RDR reforms, the list goes on. Whatever comes of Brexit in the years ahead will be small fry in relation to provisions with which the fund groups will have already had to contend post the global financial crisis.
Many U.K.-based fund groups will also have been inoculated by the Scottish referendum of 2014. This forced them to examine potential multi-region domiciles and operational bases. Many fund groups may not have changed anything as a result of the Scottish vote, but they will have the existing compliance blueprints in place which are perfectly adaptable in the current environment.
Finally, fund houses across all domiciles have been getting fitter through the competition of a truly global and multifaceted industry. Fee compression has forced innovation, the passive industry has forced innovation and increasing levels of investor consumer sovereignty has forced innovation. Fund groups today are lean having already been forced to trim non-performing aspects of their businesses.
Ramifications for product development
The Brexit result will potentially see a short slowdown of new launch development. Fund groups might take stock of product development and re-consider their strategic options. Examining the 350 or so U.K.-domiciled fund launches year-to-date 2016, a significant proportion have been absolute return offerings. This reflects one particular success story of recent times. In the 12 months to May 2016, these products collected over £7 billion in net inflows.
Exhibit 5. Daily Rolling 10 Day Volatility of UK fund Sectors
Ironically the recent performance of this aggregate product group has been less than stellar and this may now be a saturated market. In a “lower for longer” rates environment fund groups need to ensure they can meet demand for income. The funds flocking to Dublin-based money market funds in June and July won’t want to stay there for long. Analysis of fund flows data for July suggests that bond funds appear to be benefiting already from some of the cash swilling about. The thirst for yield remains unquenched.
Opportunities always knock
As we sit here in the U.K. it is easy to overstate the effects of what is undoubtedly a major democratic consequence. But in context, Brexit is a local, rather than a global event. Even as fund volatility spiked in the days after 23 June, you could buy or sell whatever securities you wanted in whatever quantities you wanted. Even commercial property funds (not all of which suspended trading) have begun to re-open with many now seeing the potential opportunities a devalued Sterling reveals.
The managed funds industry is dynamic, innovative, and far more resilient than a local geopolitical event. June and July European fund flows don’t paint a particularly pretty picture and there might be more to come. But the financial services industry has experienced much, much worse before.