Brexit redux: What to trade on?
Deadlines for Brexit, the UK’s departure from the European Union, have come, been missed and gone with dizzying frequency over the past four years. Another one is rapidly approaching.
This one, the terms under which the UK and EU will trade with each other in the years to come, is important. Despite that importance there is – yet again -- no sign for a deal. The hard deadline for reaching an agreement is the final day of the year, and the EU says it wants to reach an agreement by October so that the European Parliament can pass the necessary legislation before the December 31 deadline.
The odds of the deadline being met are shrinking. Both the UK and the EU are dealing with the Covid-19 pandemic, and the EU’s attention is focused on the economic problems of its members geopolitical issues such as the rising tensions between Greece and Turkey. So a trade deal, and the economic forecasts that will stem from it, could be in limbo for some time.
How can EPFR data help in navigating waters where neither side can agree on where the channel markers should be placed? In this week’s post, we will take a more in-depth look at two options.
A contrarian indicator for contrarian neighbours
When looking for quantitative signals generated by EPFR data to help balance exposure between the UK and Continental Europe, our first port of call is the relative flows for funds mandated to invest in UK equities and funds with broader, pan-European mandates.
To build the quantitative framework for this particular signal, we start by summing active daily equity flows to the following dedicated European Country Funds: Austria, Belgium, Slovak Rep, Denmark, Finland, France, Germany, Greece, Italy, Netherlands, Portugal, Spain and Ireland. Then, we normalize this summation by the total assets invested by all EPFR-tracked funds in the same set of countries.
This indicator serves as our daily sentiment proxy for European countries. For the UK, we look at total flows to the dedicated UK Equity Funds, again calculating a normalized flow metric. This metric is the same metric that our quant team has discussed in their 2018 paper, Fund Flows as Country Allocator (1).
With these flow percentage factors in hand, we calculate 10-day trailing summations for both. And, finally, we run a simple contrarian strategy. When 10-day flows to Europe are higher than the UK flows, we go long on the UK and short on Europe Ex-UK, and vice-versa when UK flows are higher. (The back-tested results over the past 13 years are summarized in Figure 1 below.)
This simple strategy generates a long-term Sharpe ratio of 0.64 and per-annum excess returns of 6%. The return post-2017 has been particularly eye-catching, with the Sharpe ratio jumping to 1.47 and the annualized excess returns to 11% per annum.
This indicator would be an exemplary proxy for comparing the risk appetite against Europe vs. the UK and can help investors navigate between to the sides of the English Channel.
Bull in an FX shop
Our second strategy, a version of EPFR’s bullish sentiment indicator, utilizes EPFR's newly built FX Allocations dataset. EPFR has begun collecting data on allocations of funds to currencies, and these allocations can be used to drive several remunerative quantitative strategies. One of those pairs the British pound (GBP) and the Euro (EUR).
This iteration of the bullish sentiment indicator, applied to EURGBP, is based on the percentage of active funds overweight either Euro or the GBP vis-à-vis that fund's benchmark. We use monthly changes (the first difference of the time series) in those percentages to decide whether to go long or short the Euro (GBP). The table below shows the average return difference when going long in the Euro (GBP) when this bullish indicator's monthly change is higher than the GBP (Euro).
This strategy generates a Sharpe ratio of 0.85 and an annualized excess return of 6.7% per annum.
Anchors in a trade squall
These two strategies have generated positive returns recently, and show promise as anchors for investors who find themselves in the choppy waters created by the looming trade deal deadline.
Looking at fund flows and investing from a contrarian perspective based on Europe vs. the UK switches, flags excessive moves and enables fund managers and investors to act accordingly. Looking at the changes in the bullish indicator for Euro and GBP provides investors with a good proxy for shifts in risk appetite towards both currencies.
Whether there is a deal or not by the year-end deadline, one thing is certain: there is a bumpy road ahead. Looking at EPFR data, and the use cases highlighted in this post, can help investors navigate these uncertain times.
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