8th April 2015
Royal Dutch Shell has announced a £47 billion merger deal with BG Group, which would make the combined company worth 9% of the FTSE 100, if it goes through. Hargreaves Lansdown sets out what investors need to know…
UK funds may have difficulty accommodating the size of the new enlarged Shell group, because of rules which limit a fund’s exposure to any one company.
Options for passive investors
Laith Khalaf, senior analyst, at Hargreaves Lansdown, says: “The new merged entity would be by far the biggest company in the UK stock market, and its size would present difficulties for some funds which invest in UK shares. In particular closet trackers and pension funds could eventually find themselves outside of their comfort zone in terms of their active position, unless they rejig the rest of their portfolio to look more like the index to compensate, or abandon their index-hugging philosophy.
“If the deal goes through it will be almost unthinkable for active managers to overweight the stock without putting an awful lot of eggs in one basket. However, active managers are mostly underweight Royal Dutch Shell at the moment, and the merger may prompt some to consider increasing their exposure.
“Out and out tracker funds will automatically maintain the same weight in the stock as the index, and passive investors should consequently give some thought to how much of their portfolio would be exposed to just one company, if the deal is ratified.”
‘Never sell Shell?’ Some funds may have to
The new combined group after merger would make up around 9% of the FTSE 100, based on its current valuation, and around 7.5% of the FTSE All Share. This may in due course present a challenge for some pension funds and closet trackers, which manage their portfolios largely in line with the benchmark index.
This is because regulations prohibit active funds from holding more than 10% of their portfolio in one company. While this is not a problem at current valuations, should the combined group breach 10% of the UK stock market, for instance on the back of an oil price recovery, these funds may find themselves having to sell Shell stock to comply with this rule.
They do not have to own Shell at all if they don’t want to; they are in theory active funds. Many of these funds will voluntarily limit how much they can deviate from their benchmark however. So if Royal Dutch Shell does rise significantly above 10% of the index, they will become increasingly underweight the stock. This might cause them to review their investment policy, or to make the rest of their portfolio look more like the index to compensate.
Why more active funds may decide to invest in Shell
The size of the new combined group would make it almost unthinkable for active managers to overweight the stock, as it would make up a huge amount of their fund. Even Neil Woodford, a manager known for his punchy positions, currently holds 7.4% of his portfolio in his biggest stock, AstraZeneca.
As it is, given Royal Dutch Shell’s already large size in the index, only 4% of active managers are overweight the stock. The increased size of the company will likely put a further dent in this number.
The remaining 96% of active managers are underweight the stock, with six out of ten active managers not holding any Royal Dutch Shell at all. The merger may prompt some of these managers to consider increasing exposure for the following reasons:
1. One in six managers who don’t currently hold Royal Dutch Shell, do hold BG Group, so stand to become Royal Dutch Shell shareholders unless they sell out. BG assets and operations will continue as part of the larger group, with anticipated cost savings to boot, which will tempt some to stay on the share register.
2. Some managers may feel increased pressure to hold the stock, as the merger makes their bet against the index even bigger if they maintain their current underweight position.
3. Some may feel Shell is effectively calling what it believes is the bottom of the oil price slump by making such a bold move, perhaps a reason to invest in the sector.
4. Yet others may be attracted by yield, rendered even more attractive by today’s fall in Royal Dutch Shell’s stock price. The yield currently stands at around 6% for ‘B’ shares in 2015, based on current market prices. With the 10 year gilt yielding around 1.6%, that looks like a healthy premium, despite the headwinds the oil and gas sector is currently facing.
Tracker fund investors should consider concentration risk
Tracker funds have a special exemption in regulations, allowing them to hold up to 20% of their portfolio in any one company. They can therefore happily continue to track the index weighting of the new enlarged group if the merger proceeds as expected.
However tracker fund investors should pause to consider how much of their portfolio is dependent on the performance of just one company in this scenario. This is particularly the case for investors in FTSE 100 tracker funds, though it also applies to FTSE All Share tracker funds.
Options for passive investors
If passive investors decide they would have too much exposure to Royal Dutch Shell, they have a number of diversification options:
1. Add a FTSE 250 tracker fund into the portfolio to add greater exposure to medium-sized companies. These tend to be more volatile than blue chips, but also tend to offer greater long term returns, as well as diversification benefits. We like HSBC FTSE 250 Index fund, which is available from an annual fund charge of 0.07%.
2. Add an international tracker fund into the portfolio to diversify into other parts of the world. Our pick would be Legal & General International Index trust, which is available from an annual fund charge of 0.08%.
3. Add an active UK fund into the portfolio, preferably one with a healthy disregard for the constituents of the benchmark. Lindsell Train UK Equity pays no attention to the benchmark, though it is a concentrated portfolio, so investors would need to scale their investment appropriately. The fund is available from an annual fund charge of 0.57%.