Brexit putting investments in stark light

The U.K.'s plan to leave the European Union is already affecting the way some institutional investors and money managers are thinking through their allocations and investment tenets in the region.

Some clients are asking money managers to ring-fence U.K. assets from pan-European allocations, segregating the exposure either to give them greater control and active management of that allocation or to enhance risk management, sources said. Other investors are now considering the U.K. and Europe as separate entities when acting on their investments.

"It has always been very much two Europes for us — now it's three," said Olivier Rousseau, executive director at the €36 billion ($42.3 billion) Fonds de Reserve pour les Retraites, Paris. "We have always had an allocation to the eurozone and to Europe. And now I should say we should think in terms of three Europes – eurozone, the U.K. as such because of Brexit in particular, and the rest of Europe — Switzerland and (the) Nordic markets." FRR has a "very small ​ allocation" to the U.K. via its Europe exposure, he said.

A statement from the €26 billion Etablissement de Retraite Additionnelle de la Fonction Publique, Paris, said: "Clearly Brexit will lead investors to reconsider the level of their exposure to (the) U.K. The most immediate impact for those that are already invested is linked to the pound depreciation. It has been quite impressive and many investors' boards are sensitive and asking questions to the investment departments."

While ERAFP executives said the U.K. "will not lose all the features that contributed to make it prosper ... one might doubt that a hard Brexit would not adversely impact the financial sector that has been contributing so much" to the country's growth. "ERAFP will be looking cautiously to any additional exposure to U.K.," said the statement.

Europe ex-U.K. pension funds "have historically considered a whole Europe equity region, and are now beginning to split things in order to manage exposure — particularly where the U.K. is a very sizable part of the region and risk factor relative to the home country of the pension fund," especially if the fund is based in Switzerland, Sweden, Denmark or Norway, said Nikesh Patel, London-based head of investment strategy, U.K., at Kempen Capital Management.

However, a complicating factor is defining U.K. exposure "when it comes to trying to manage Brexit-related risks on these pension funds, as you need to look beyond the geographic location of the stock listing and to the underlying earnings, which for the majority of the largest U.K. equities, are generated outside the U.K. This second step is typically carried out by active managers. We do this for our clients, but we see little evidence of a major trend amongst large European pension funds to do this strategically," Mr. Patel said.

Hazel McNeilage, London-based managing director for Europe, Middle East and Africa at Northern Trust Asset Management, said clients are thinking hard about how to position themselves for flexibility, headwinds and continued uncertainty for the U.K. The firm's latest five-year capital markets assumptions outlook report puts Europe ex-U.K.'s five-year annual return at 7.2%, compared with a U.K. forecast of 6.6%. "Historically our forecasts for the U.K. tended to be above that for the rest of Europe."

The desire for increased flexibility has pushed the firm's "large, sophisticated clients" to look for customization in the way their assets are managed, she said. Some are looking to broaden the reach of their equity portfolios and benchmark to the MSCI All Country World index, combining developed and emerging markets and enabling them to smoothly rearrange their exposures among regions.

"And then very specifically we do have some clients — a smaller number, but they are certainly very large — who specifically arrange their portfolios on a regional basis," such as U.S. or European equities, Ms. McNeilage said. "It is in that part of our client base where we have seen some instance of … a European equities portfolio being split out into Europe ex-U.K., and then a separate U.K. portfolio," she said.

Cai Rees, a director in SEI's institutional advice team in London, said the separation question is "a very familiar issue to us. I would say Brexit might have pushed the market forward a little more quickly in seeing them separately." Firm executives already view the U.K. as distinct from the rest of Europe.

Some money managers have Europe ex-U.K. equities portfolios and specific U.K. equities allocations.

How to handle Brexit remains top of mind to investors, said Daniel P. Farley, chief investment officer of the investment solutions group at State Street Global Advisors, Boston. Separation of the U.K. from the rest of Europe in portfolios is "more conversation than action at this point," he said, and there remains uncertainty over what Brexit will look like. "Our view is to take any specific moves right now is a little early until we have better clarity."

He added that clients will have different views depending on their location and what they consider their "home" region. Continental Europe clients often view the eurozone as their domestic region, "so often in the past they may have excluded the U.K. as part of that."

Jim Smigiel, CIO absolute-return strategies at Oaks, Pa.-based SEI Investments Co., said the firm is not making any Brexit-related changes to its asset allocation framework for U.S. clients, but is "paying special attention to the U.K. for tactical themes in equity, currency and interest rate space."

With about 75% of FTSE 100 company earnings derived overseas, the locality behind an exposure is being closely analyzed by firms and clients thinking about the impact of Brexit. For the FTSE 250, about 50% of revenues are derived overseas, sources noted.

Psigma Investment Management CIO Tom Becket in London said firm executives have always separated European and U.K. equity allocations. Executives then work out "which we believe are international and domestic-focused companies," which are likely to be negatively affected by the Brexit negotiations. There has been a "wide chasm between the performance of internationally focused businesses, which have done well from (the impact of Brexit on) sterling, vs. U.K.-focused firms suffering from the weakening U.K. environment," he said.

Mr. Becket added the "U.K. allocation is taking up a great deal more time than it has done previously" in portfolios. "In terms of clients, trustees, etc. asking questions, the vast majority are around Brexit … and the outlook for the U.K. economy, and what we're doing about U.K. allocations."

Added Mr. Patel: "Whilst European ex-U.K. funds are beginning to shift their mindset in this way, this is not the case for U.K. pension funds — (they) already consider their equity allocations to U.K. and Europe ex-U.K. separately." He said some are taking a closer look at where earnings are sourced.

A number of money managers contacted by Pensions & Investments said they are not receiving questions about carving out U.K. exposure from pan-European allocations, but that doesn't mean executives are not thinking that way for the future.​

"We're having a discussion on product — traditionally if you built a euro-equity portfolio to sell globally, you would have U.K. (exposure) in it," said David Hutchins, a London-based senior vice president and head of AllianceBernstein LP's multiasset solutions business in EMEA. "You could argue going forward that European equity portfolios may not have the U.K. in them anymore."

He said clients wanting to play the European growth theme will base investments on the eurozone.

"You could argue those kinds of things might come through — more where you're selling to someone trying to play a certain theme. It's a debate we have within the multiasset team: we have country models about how to rotate between certain countries, and I'm a strong advocate we shouldn't have the U.K. in it as it doesn't provide a linkage to the U.K. economy," added Mr. Hutchins.