The UK’s withdrawal from Europe leaves the country’s investment managers reliant on the EU deeming its regulatory systems equivalent.
This risk highlights how integrated the industry has become within the European market and regulatory system and how other opportunities have been less intensively developed. The growth of Asia’s economies and capital markets together with the UK’s new proposed regulatory approach presents opportunities for UK investors wishing to directly access local talent, specialist strategies and established funds.
The end of the Brexit transition period marks a period of increased risk for UK-based investment businesses as many firms have become highly integrated into the EU market, benefitting from its single regulatory standards, significant distribution opportunities and economies of scale. Now outside the EU, firms risk these benefits being eroded through diverging regulatory systems, substance requirements and more complex infrastructure.
UK investors will wonder whether this has any implications for them and, if so, what these might be.
Being part of the EU’s regulatory system and investment market has benefitted investors by providing access to a wider range of managers, choice of exposures and range of products. However, it has restricted use of alternatives such as hedge funds, while the EU regulatory system’s protectionism has put off new entrants from outside Europe, who in practice have to establish new European domiciled UCITS funds with costly infrastructure, substance and capital requirements.
The attractions of the EU investment market, in particular promoting funds bearing the highly successful UCITS brand, has pre-occupied UK firms so they have been less focused on investment centres where their flagship UCITS fund ranges are not marketable.
But after Brexit, UK-based investment managers to a great extent rely on the EU continuing to deem the UK as having an equivalent regulatory, supervisory and enforcement regime thought necessary for a ‘high impact’ country. As UK based fund managers run assets of around £2trn for continental European investors, given the lengthy and at times acrimonious withdrawal negotiations, together with certain countries’ aspirations to expand their financial centres, the possibility political disputes could imperil the equivalence status allowing these activities makes this a remote but high impact risk.
This change in status quo does however open up new opportunities, as the UK’s proposed Overseas Funds Regime places regulated funds from selected countries on a level playing field with EU UCITS. This means funds in jurisdictions determined by the UK authorities to be equivalent, meet specific criteria and are approved by the UK regulator, will be permitted to be marketed to UK investors. Equally UK firms’ funds will have reciprocal access to investors in those other countries.
This approach follows similar principles to the existing mutual recognition arrangements with Hong Kong. It is notable this flexibility has thus far barely been used by managers based in either jurisdiction, even though it provides a rare opportunity for medium- and small-sized UK and Hong Kong-based managers with complementary strategies to partner in developing reciprocal new distribution opportunities.
These reciprocal arrangements introduce the prospect of improved access for investors to Asia, home to almost 60% of the world’s population. Economic growth in developing Asia is above the global average, contributing to a rapidly growing middle class, estimated to total 3.5 billion by 2030, more than five times the size of the middle class in the Americas.
Asia’s capital markets continue to be a fraction of the size of those in the US. The combined market capitalisation of companies listed on US markets represent US$39trn, while China’s domestic stockmarkets, excluding Hong Kong, passed US$10trn in 2020. In 2019 China’s domestic stock markets represented just 59% of GDP, in line with other developing countries, although well below the likes of Japan (122%) and US (174%). Assuming the state’s policies continue to encourage development of equity-based corporate funding and promoting access for foreign capital, it is likely China’s stockmarkets will continue growing both as a proportion of the economy and in absolute size.
As Asia’s economy grows in global importance and its capital markets develop, institutional investors’ allocations will rise from today’s low levels of below 5%, with some advisors discussing portfolio allocations to China of as much as 20% by the end of the decade. While large institutions able to invest in costly infrastructure can allocate to the region’s less accessible markets and investments, these opportunities are not available to smaller investors.
Although today many investors rely on Western firms to remotely manage assets in Asian markets or adopt passive index strategies, in time more adventurous investors will see the merits in investing with local boutique managers that are close to the market and already running established funds for domestic investors. As Asia’s capital markets deepen the number of specialist strategies benefitting from on-the-ground presence and local insights are expected to grow.
Certain sophisticated institutions already invest through non-EU funds to directly access this kind of local market expertise and trade while stock markets are open, but post-Brexit regulations will make this flexibility a possibility for a wider range of investors. Local products can provide more granular exposure, efficient local execution and, in certain cases, lower investment costs, as in the case for some Japanese and Hong Kong-listed ETFs investing in domestic companies.
Another benefit for UK investors is the freedom to invest in overseas managers’ established funds, making it more viable to access, for example, Australia and New Zealand’s mature capital markets that provide exposure to specific sectors of Asian economies. In many cases this will be preferable to trying to achieve the same thing through small, high cost UCITS funds that have no established track records.
So while the impact of Brexit may be unwelcome in many ways, in the long run UK investment managers and investors will come to regard the event as a catalyst for further diversification that encourages a greater focus on the opportunities in Asia’s dynamic economies. For investment managers seeking new distribution markets for their funds this constitutes a rare opportunity in today’s highly competitive environment.
Geoffrey Post is an independent product and distribution consultant, specialising in developing links with Asia