It feels opportune to be writing about UK equity funds at a time when the FTSE All Companies index return to date this year would be placed in the first quartile of the IA UK All Companies sector. By comparison, it would have featured in the third quartile in 2015. It is somewhat unusual to see the index doing quite so well. To some extent, this represents a reversal of some of the trends and dynamics that have previously been at play.
This year started in a turbulent fashion, with global stockmarkets heading south. Many of the main themes of 2015 continued to set the tone: namely China growth fears, the broader emerging markets slowdown and continued weakness in the oil price. Attention also turned to deteriorating economic data in the US and worries the Federal Reserve’s rate hike may turn out to be a policy error.
There were two important trend reversals in the first half of the year:
Mid-caps have enjoyed an extended period of outperformance but this year large-caps are leading the way. The mid-cap index, over five years to the end of 2015, returned 72.9 per cent, while the FTSE All Companies index returned 33.8 per cent. UK small-caps (ex-investment trusts) performed even more strongly than mid-caps over that period.
In a world still struggling with the ramification of the financial crisis, economic growth has been muted and so those companies generating profit growth have been prized. Hence the relative strength of small- and mid-cap stocks.
Most managers in the UK All Companies sector have the flexibility to invest lower down the market cap scale, so, in aggregate, the sector is overweight mid-caps compared to the FTSE All Companies index. Not surprisingly, the sector average has performed relatively well, benefiting from this market cap effect.
Against this backdrop, many fund managers we spoke to at the start of the year commented that UK small- and mid-cap valuations looked stretched, especially as the global economic backdrop remained challenged, making it tougher for companies to grow their earnings. These valuation concerns, combined with a difficult start to 2016, saw many managers reduce their exposure to small- and mid-caps in favour of more defensive and/or internationally-orientated large companies.
At the other end of the spectrum there were a number of sectors in 2015 that were unloved, arguably cheap and possibly troublesome. It is fair to say large swathes of the index have had their particular issues over recent years: banks have been in a rehabilitation phase, oil and gas companies and miners have been in a price adjustment phase, and pharmaceuticals have been in a restructuring phase.
This year has seen something of a reversal of fortunes in some areas. The mining and oil and gas sectors have experienced a bounce, albeit with volatility, and the much-maligned supermarkets have rallied from oversold territory, notably in the first quarter.
A sector that has not participated in the same way is financials, given the ultra-low interest rate environment and a host of other challenges for banks in particular.
The fact few fund managers were fully exposed to many of these unloved areas was helpful for them in 2015. However, this positioning has clearly been a headwind this year and, in particular, a general underweight to materials has been a common cause of funds’ underperformance versus the large-cap index. Those funds with a value bias and a focus on recovery situations have tended to fare very well to date this year.
A persistent theme
One persistent theme has been the ongoing love affair with “expensive defensives”. The long march down in bond yields has left “quality, safety and income” in highly-valued territory, as investors have been on a hunt for yield and have sought out relative security against an uncertain economic backdrop. Market volatility at the start of the year saw yet another flight to safety and diminishing interest rate fears, in the US at least, has further supported sectors such as tobacco.
Where do we go from here?
We have seen some remarkable outcomes from the UK All Companies sector so far this year. Schroder Recovery, for example, a recommended fund within The Adviser Centre, is managed according to a deep value style and, after a challenging 2015, has delivered an exceptionally strong return. Conversely, dedicated mid-cap funds are in negative territory. So, where do we go from here?
- More of the same: monetary stimulus continues to support the “expensive defensives”. Income funds are likely to fare well. Genuine growth stocks would also be in favour in a low growth world.
- Economic growth reasserts itself but with limited headline inflation: the market overall would likely do well but the beloved “bond proxies” would lag.
- Monetary/fiscal stimuli are successful in helping the economy to accelerate and in boosting inflation: value managers with exposure to real economy areas, such as “nut-and-bolts” industrials and consumer-facing financials are likely to outperform.
Marianne Weller is senior investment analyst at The Adviser Centre