Experts advise investors to exercise caution in the face of the volatility likely from the June Brexit vote.Jason Alden/Bloomberg
The coming June 23 referendum vote in Britain on whether to remain in or exit the European Union – the so called Brexit decision – has produced something capital markets around the globe hate: uncertainty.
As a result, some Britain-based investments, including exchange-traded funds, which track an index, but can be traded on a stock exchange, have experienced volatility.
Experts advise investors to exercise caution in the face of this uncertainty and volatility, which is expected to peak as the date of the referendum approaches.
"Long-term investors should maintain a well-diversified portfolio that is in line with their risk tolerance, and ETFs can be part of that," says Anish Chopra, managing director of portfolio management and research at TD Asset Management Inc. in Toronto.
But they need to keep an eye on how the potential market impacts of the pending referendum might change their investment plan.
"Investors may consider re-aligning their asset mix if volatility in European and U.K. equities was to increase, so that risk at the portfolio level remains in line with the investor's risk tolerance level," Mr. Chopra adds.
He expects that currency-hedged international ETFs would be shielded from potential declines in the British pound and the euro and therefore might outperform their unhedged counterparts.
"Due to their exposures in Europe and the U.K., international ETFs would likely be negatively affected, at least in the short term, given that a U.K. exit would likely lead to increased uncertainty," he says.
Peter Westaway, the London-based chief economist for Europe at Vanguard Asset Management Ltd., says opinion polls are close at the moment, although he believes that most predictions still tend to favour Britain remaining in the EU.
There is, he says, no simple portfolio strategy to follow to make money from the Brexit debate.
"If you really thought that Brexit was going to occur, perhaps the obvious thing to do is avoid anything with [pound] sterling U.K.-based ETFs. But if it turns out that the Brexit is avoided, then we should probably expect to see a rally in sterling assets. The sort of advice that we tend to give investors – whether one is talking about Brexit, or more generally about geopolitical risks and general risks – is not to try and be too clever by trying to second guess how things are going to play out," says Mr. Westaway.
Daniel Girard, a portfolio manager and investment adviser with CIBC Wood Gundy in Waterloo, Ont., says the common ETF used by North Americans for international exposure to that part of the world is the Europe Australia Far East [EAFE] index. About 75 per cent of the EAFE exposure is to Europe, and within that 75 per cent, there tends to be about 20 per cent to 25 per cent exposure to British companies.
"If you want European exposure and you want to take out the Brexit issue, you can hold the EAFE index and not really worry about it, because EAFE is holding companies all throughout Europe," Mr. Girard says.
"At the end of the day, if everybody spends the same amount of money in the EU, it's going to go to some EU company, whether it's a U.K.-based one or elsewhere, so by holding the EAFE index, you hedge out and negate the whole issue," he adds.
But for somebody who is guessing Britain will vote to leave the EU, and thinks that will be beneficial to Britain, and who wants to play that issue, they might want to consider buying an index that only owns British companies, says Mr. Girard. One example could be an ETF linked to the FTSE 100, which is an index of the largest capitalized companies listed on the London stock exchange.
On the other hand, if an investor expects a Brexit, but that those results would be negative – with the pound likely to decline in value in such a scenario – they might consider a strategy of selling an index short. Selling short could happen if, say, somebody held an ETF linked to the FTSE 100 by virtue of having borrowed it with the obligation to pay it back later, he says.
"If you thought the British pound was going to drop in value you may short the FTSE 100 index, and then convert the cash to, say, U.S. dollars or the euro. You're selling a security you don't own in the hope that it drops in value so you can buy it back cheaper later. If I can go back and buy it for less than I sold it for, I've made a profit," Mr. Girard explains.
Short-selling, however, carries risk.
There are also fixed-income ETFs that are exposed to bonds in pound sterling, says Mr. Westaway, who warns there is a danger in assuming that in the event of a Brexit, only the British currency and assets would be affected.
"I think that would be a very bad mistake because if the U.K. did leave the EU, there's a good chance it would then have knock-on adverse effects on European assets, as well.
"Indeed some people argue that if the U.K. left the EU it could set in train a set of dominoes falling where other countries might start thinking about leaving the EU. It might undermine the euro," he explains.
Mr. Girard emphasizes that share prices are also determined by corporate earnings, and that he doesn't think the impact of the Brexit vote will have a significant effect on his clients with a longer-term horizon of three to five years or more.
"It will cause short-term volatility for sure. Financial markets abhor uncertainty. So likely with Europe when the vote gets closer, volatility will pick up in the currency, bond and stock markets. But outside of a one-, two-, three-year time horizon, it's probably immaterial."
"There will be winners, there will be losers, in general. [But] it will net itself out is our belief," he says.