* Dividend funds, index trackers dominate inflows
* Foreign buyers put off by sterling slide
* Handful of large-caps soaking up flows
* GRAPHIC: FTSE 100 vs FTSE 250: bit.ly/2e3GHSu
* GRAPHIC: The pound's slide: tmsnrt.rs/2egbfVh
By Vikram Subhedar
LONDON, Oct 13 (Reuters) - As sterling plumbs the depths, foreign investors are withdrawing from British stocks and leaving domestic funds to push the benchmark bluechip index to record highs - for now.
But some investors are growing nervous about how long the sterling-based funds, insulated from the pound’s slide and drawn by healthy dividend yields, will continue to fill the gap.
The FTSE 100’s sharp recovery from lows after Britons voted to leave the European Union in June stands in stark contrast to a darkening outlook for the pound and the domestic economy.
In sterling terms, London-listed stocks have raced to their highest ever levels even though investment funds have continued to bleed money, share valuations are near multi-year highs and the outlook for earnings remains muted.
Data from Thomson Reuters Lipper shows that from June to September, UK-focused equity funds suffered outflows of more than 3 billion pounds ($3.73 billion).
Much of this appears to have been pulled by investors based in dollars or euros. While the FTSE is up nine percent from the EU referendum day of June 23, the pound has lost 18 and 15 percent respectively against their home currencies - wiping out their notional gains.
At its latest policy meeting, the Bank of England noted estimates from S&P Global Market Intelligence suggesting that net purchases of FTSE 100 shares by non-residents in July and August were about half of the average monthly inflows last year.
Still, the FTSE 100 rose 13 percent from June to September and is up by more than fifth since its lows in July following the shock referendum result.
The composition of the UK index along with the kind of investors active in the market helps to shed some light on what is underpinning stocks.
Dominated by large, dividend-paying, global companies - many of which receive a big earnings boost when they bring offshore revenues home thanks to the weak pound - the FTSE 100 hit the sweet spot in a world where yields on investments are scarce.
With yields on British government bonds near rock-bottom, this is particularly the case for domestic investors for whom currency is less of a factor.
“The UK remains an attractive place for investors seeking dividends; there are 15 companies with an indicative dividend yield of over five percent, which is significant when compared to the one percent yield on 10-year gilts,” said Matthew Beesley, a portfolio manager and Head of Global Equities at Henderson Global Investors.
Less than 10 percent of the roughly 600 UK-focused equity funds tracked by Lipper have enjoyed net inflows since June. Inflows are heavily skewed towards so-called income funds, which aim to pay their unit holders dividends, and tracker funds, which passively buy stocks in a given index.
Nick Train’s $3 billion UK equity fund, which had a fifth of the fund in shares of drinks group Diageo and consumer goods giant Unilever at the end of September, attracted the most inflows with more than $440 million.
Both Diageo and Unilever exemplify the kinds of major stocks that investors have increasingly gravitated to since the Brexit vote, drawn by their dividends, relatively low reliance on the British economy and the boost from offshore revenues.
British fund supermarket Hargreaves Landsdown, which caters largely to domestic retail investors, on Thursday posted record profits and assets under management for its latest quarter, but said investors’ confidence had fallen and this could weigh on future business.
Equity income funds were in demand in a low interest rate environment, chief executive Ian Gorham told Reuters.
The large dividend payers are also among the biggest listed firms in the UK and with the FTSE 100 weighted by market-capitalisation, the larger a firm the more influence its wields on the index’s moves.
Just 10 large stocks make up nearly half the market-cap of the FTSE 100. Exchange-traded funds (ETFs) based on the index, which overwhelmingly favour bigger stocks, are the only other group to have seen inflows since June.
Oil majors BP and Royal Dutch Shell and emerging markets-focused banks HSBC and drugs group AstraZeneca, are all big outperformers and have been key in lifting the broader index.
Eric Moore, a portfolio manager of the Miton UK Income fund who holds AstraZeneca shares, says the company is one among a handful that pays out dividends in appreciating U.S. dollars, making them even more attractive to British investors.
“It may be a one-off mechanical adjustment but right here, right now the impact is real. It’s money in the bank,” said Moore, who adds, however, that the sustainability of dividends are a concern as payouts have grown faster than a recovery in corporate profits.
The view from across the Atlantic is less sanguine.
Offshore investors are less enthusiastic about investing in UK assets due to the growing likelihood of a “hard” Brexit - in which Britain leaves the EU’s single market in order to impose controls on immigration, disrupting access to its main trading partner.
More than half of UK stocks are held by overseas investors, according to the latest data from Britain’s Office for National Statistics. Foreign holdings were less than 10 percent in the 1970s and 1980s, and stood at around 35 percent at the turn of the century.
Cumberland Advisors, a Florida-based investment firm that uses mostly ETFs, points out that the main UK ETF used by U.S. investors, the iShares MSCI United Kingdom ETF, has lost money this year. A currency-hedged version is up, though the fund’s assets under management are considerably smaller.
Bill Witherell, chief global economist at Cumberland Advisors, said a weaker pound is positive for UK multinational firms only as long as single-market access continues.
“The prospect of a weaker domestic economy and heightened policy uncertainty lead us to maintain our maximum underweight of the UK in our International, Global, and Tactical Trend ETF Portfolios,” said Witherell.
The FTSE 100’s climb above the 7,000 point level has taken valuations to 16 times forward earnings, close to the highest in a decade.
It has brought back some uncomfortable memories. The three instances when the index was around these levels were just before the dotcom bust in 1999-2000, the collapse of the Northern Rock bank in 2007 and during last year’s Greek debt crisis.
“After 20 years in the business, I can’t help but feel a little jittery about the FTSE around here,” said Moore.
($1 = 0.8042 pounds)
Additional reporting by Danilo Masoni in MILAN and Simon Jessop in LONDON, Editing by Mike Dolan and David Stamp