There is an old story about the Great Depression. After the crash in 1929, a reporter went to a bar close to Wall Street and asked the bartender how he might be affected by what had transpired. He replied, “It doesn’t matter. In the good times, I sell champagne. In the bad times, I sell beer. I make the same amount of money either way.”

Living in London after “Independence Day” is a pretty humourless affair (apparently the new movie is too – how ironic). From what I hear on the streets and in restaurants around town, people are tense and mostly sad. I will leave the rest of what could turn into a long rant about the ridiculous state of British politics to others; the big question for me is where all this potential upheaval leaves the fund management industry.

The Silver Lining
Each crisis is different, but fundamentally the same. We don’t know if this will be a storm in a teacup, or an important stage in a much larger crisis. There are two things that could play in the industry’s favour (or at least mitigate some of the risks).

1. The Regulatory Risk
So I have been trying to work out what the impact of a Brexit will be on the fund industry, and have been working my way through what the major publications have to say on the matter. Dechert released a report outlining that, for the most part, the impact will be limited (from what I have read, I am not a qualified legal expert). Most onshore managers that have a European-wide focus on fund distribution use Luxembourg or Ireland as a domicile for their funds. The manager, whether they are in Europe, the U.K. or the USA is appointed as Investment Advisor for a European Management Company. There is a question about what will happen to UK OEICs marketed into the EU (there are not many). Or, perhaps European domiciled funds marketed into the UK. For the moment, it seems like the risks are fairly well mitigated and there is enough time to launch new structures fairly cheaply.

For hedge funds and other alternatives, UK based AIFMs will need to reclassify, but this also appears fairly straightforward and there is plenty of time to react.

Mifid appears to be manageable, as well.

In short, the alternatives industry has already been clobbered by EU regulation, and it is hard to see what more the EU could possibly do to make the situation worse than it is already. There could be a potential issue when it comes to selling UCITS products in the UK, but who knows?

2. The biggest reason to be happy about a dismal situation: Understanding how asset allocators make their decisions.
It took me a long time to understand that allocation volatility doesn’t happen when everything is in a steady state. What do I mean by this?

If I am an allocator and the status quo is playing out, then I would only consider an allocation switch if what I found was considerably better than what I had already, in terms of a range of conditions.

If I received more money to invest, then I would not necessarily disturb my asset allocation; that said, I may consider diversifying my fund choices to include other alternatives.

When there is a major shift in the world, “all bets are off.” Case dependent, I may need to become more defensive or take more risk. Consequently, a passive ETF becomes an actively managed fund. An actively managed fund becomes a Long/Short product. A Long/Short product becomes a Market Neutral manager, and so on. Investors start asking themselves: Is there a better opportunity in Credit? Have other countries been impacted less? Or, are there cheap stocks ripe for M&A in the UK or the Eurozone? The possibilities are endless.

One thing I have learned in my 20 years of trading is that risk and reward are the same – the only thing that matters is the odds. Full price discovery and known outcomes are worthless. The night of the vote, all the polls were showing that “Remain” and “Leave” were in a dead heat. The bookies were placing 9:2 odds on “Remain.” In other words, $1 would get you $4.50 (plus your $1 back). Not factored in was the average bet size. As of June 22nd, an article came out discussing the average bet size for either outcome. 450 GBP for “Remain,” versus 75 GBP for “Leave.”

Since bookies balance supply and demand, the result is a lopsided bet. If everyone placed bets, like for like (i.e. 1:1), then the odds would have reversed (minus the bookies take). In other words, you had a 50% chance of getting paid 9:2 had you have placed a bet for a Brexit.

The takeaway from this is that Fund Managers should be experts at understanding the odds of getting things right (or wrong) and estimating the outcomes.

From what we have seen, most managers positioned themselves in readiness for a known risk. Perhaps Grexit was a good training ground?

Last week, we saw most investors taking stock of their current portfolio. Once the stories start playing out, get ready for the great rotation and for talent to manage these positions accordingly.