Brexit: How would my portfolio cope?

Another day, another dozen of Brexit comments. New poll results seemingly driving the value of the Pound. It is not easy these days for investors to ignore the discussion around this month’ vote. And probably most of you are worried that the value of your portfolio will be negatively impacted. So I hope it is valuable that we revisit two of our core investment principles.

Let me first comment on the Brexit discussion itself. Being a German guy working in the UK, I of course wonder what consequences Brexit would have on my life. But let’s recall the following truism: The only thing we know is the status quo, anything else, is just speculation. Certainly some people talk like they have the perfect crystal ball and of course some events in the future, like visiting the doctor, if you have already made an appointment, are very likely to happen. But the outcome of the vote at this point seems highly uncertain given latest poll results showing a very close race, the consequences on the UK economy seem even more uncertain given how widely different GDP forecasts are these days due to different assumptions as well as modelling techniques. Consequences on markets seem most uncertain, considering the huge swings some people predict. So we are faced with 3 levels of uncertainty piled on top of each other.

Markets are of course doing what they are supposed to, be efficient and price in all the news available. Particularly on the currency side, it seems in recent months we have seen the pound weaken whenever the probability of Brexit increased. But as polls are not the same as votes and current polls are not painting a clear picture, we could well see strong market swings when the vote result comes out. Volatility has also increased in recent months, reflecting the increased uncertainty. All other things being equal, we will probably see volatility decline if the UK people vote “Remain”. If not, uncertainty will continue, as attention will shift to the next required decisions, which of course also carry a large degree of uncertainty as to the outcome as well as the impact, so volatility is likely to remain at elevated levels.

Where does this all leave us as investors? Should we bet on a certain outcome? Should we hedge some of the seemingly obvious risks? I am sure you can all recall our investment beliefs at MASECO as well as the investment process set up based upon those. So let’s take a look. Volatility is not necessary a bad thing, as it can be viewed as an indication that some opportunities for mispricing exist in the market. None of us want to be at the wrong end of the stick but given Brexit facts don’t exist yet, many decisions would largely be driven by emotions, not by rational motives. In investing there is plenty of empirical evidence that such decisions more often than not have negative outcomes. And a hedge is nothing but taking the opposite side of a bet. In the land of derivatives, hedges using options of course have limited downside, but one pays an insurance premium for it, which in the current scenario is expensive given the elevated volatility levels. So is there nothing we can do? Yes, there is, and good news is, it has already been done.

The first line of defence is to have proper diversification in place. Our portfolio are all globally diversified from multiple dimensions. We invest across countries in both the developed and the emerging market world, both on the equity side as well as on the bond side. The same holds true on the currency side. For example, in case the value of Sterling drops versus let’s say the Euro, our exposure to European equities will increase in value.

The other measure that will help in the current situation is called rebalancing, a technique that we at MASECO have strong beliefs in and practise with great discipline. Rebalancing creates benefits from a risk angle as portfolios are brought back to target allocations and target risk levels. But there is also the often called “Rebalancing Bonus” to be considered. Of course like everything else in finance it is not harvested all the time but empirical evidence, that it creates long term performance benefits, is very strong. The impact of rebalancing mathematically is the strongest at times of increased volatility. So whatever happens in markets after the Brexit vote turns out to be in favour of leaving the EU, we view it as an opportunity. The more markets are driven by fear or greed, the more prices move away from fair value. Price volatility is higher than the volatility of the underlying data markets attempt to interpret. Therefore ratios of price and fundamental variables, also called value measures, fluctuate mostly driven by price changes. Rebalancing only looks at portfolio weights, which are also driven by price changes. As not all investment options simultaneously offer identically attractive value opportunities, one ends up systematically buying cheap and selling expensive. Isn’t that what we attempt to do anyhow beyond the investment world in our jobs and life every day?

By Helge Kostka

Risk Warnings and Important Information
The value of investments and the income from them can fall as well as rise. You may not get back what you invest. Past performance is not an indicator of future results.

The above does not take into account the specific goals or requirements of individuals and is not to be construed as advice or recommendation to invest. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.

MASECO LLP trading as MASECO Private Wealth is authorised and regulated by the Financial Conduct Authority, the Financial Conduct Authority does not regulate tax advice. MASECO Private Wealth is not a tax specialist.

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