Brexit: An Opportunity or Threat for Investors?
New research has highlighted the dangers of investing in companies with high exposure to European markets in the post-Brexit age.
Dr Thanos Verousis, a senior lecturer in accounting and finance at Newcastle University Business School, has carried out an in-depth study that analyses investors’ exposure to idiosyncratic risk – or risk which affects a particular company.
The research has led to the production of a financial model which looks at various investment scenarios and patterns, taking into account idiosyncratic risk – i.e. risk which is endemic to a particular asset and not a whole investment portfolio. Through this exercise, Dr Verousis identified a formula that helps investors increase their returns.
The key number is a 1.32% asset premium on exposure to idiosyncratic risk. Essentially, this shows investors how much more money they can make by increasing their exposure to companies with low idiosyncratic risk and selling assets that carry the highest risk. It also calls into question the long-held assumption that high-risk investments generate the best returns.
Dr Verousis says: “Idiosyncratic risk is different to systematic risk, which takes into account factors that affect all companies in the market, such as an economic downturn or outcome of an election result. The traditional assumption is that investors are rewarded only for their exposure to systematic risk, but not for their exposure to idiosyncratic risk as they have an opportunity to diversify their investment portfolio.
“However, to assume that all investors have a fully diversified portfolio is restrictive and doesn’t really describe the way in which many of them actually construct their portfolios. What about those investors who like to invest in only one or two companies? Until now nobody has been able to put a figure on the level of returns investors could get if they spent time considering their exposure to idiosyncratic risk.
“My research shows that there’s an element of this type of risk that can be accounted for by a mathematical formula. Investors can exploit this by using this formula and, if they do that, they can achieve an additional average return of 1.32%, which is quite a good result in this economic climate.”
Dr Verousis believes that investors should regularly assess and, if necessary, alter their portfolios to adapt to changes in market conditions and the fortunes of individual companies. While he makes a distinction between systematic and idiosyncratic risk, the two are not mutually exclusive. Take the decision by UK voters to leave the EU, for example.
“While Brexit could be defined as a systematic event, it affects each company differently,” he says. “The idiosyncratic risk for companies
with high exposure to the European market – including firms that export heavily to the EU, for example – has increased substantially. Generally, Brexit will increase uncertainty and market volatility, which means that EU markets have high idiosyncratic risk. That presents a danger to investors who are exposed to these markets.”
However, that’s not to say that Brexit will necessarily be a burden on investors. There will be several opportunities to profit from the decision to leave the EU if they can capitalise on the rising idiosyncratic risk of companies that are exposed to these markets.
Dr Verousis, who presented his findings at the Financial Management Association’s Annual Meeting in Las Vegas in October, says: “It’s not a case of whether Brexit is good or bad. Our model works in both scenarios, if the economy is performing strongly or poorly.
“If EU markets are more volatile and companies have higher levels of idiosyncratic risk, investors can sell shares in these firms and invest in lower-risk assets, such as pharmaceutical and food, which tend to do well in non-EU markets. That would be a good way of increasing returns which is, after all, why investors do what they do.”
Dr Thanos Verousis
Senior Lecturer in Accounting and Finance
Newcastle University Business School