Stephanie Flanders: Is the tide about to turn for commodities?

Stephanie Flanders 700 x 450

Domestic equities have long been the most important asset in UK investors’ portfolios and there is little sign of that changing. However, the peculiar structure of the UK market makes it surprisingly difficult for index investors to actually get exposure to the UK economic recovery.

Invest in the FTSE 100 today and you are likely to find any improvement in UK earnings drowned out by global earnings trends. That is hardly a surprise when you consider the businesses in this select group obtain only around 20 per cent of their revenues from the UK on average (see chart).

Another quirk of the UK equity market is its high concentration. FTSE 100 companies account for around 80 per cent of the market value of the All Share, and the top 25 per cent of stocks, ranked by size, account for nearly 90 per cent of the market. The equivalent number for the main European and US indices is closer to 70 per cent.

This concentration has weighed on the long-run performance for the FTSE All Share in recent years, when the small and mid-cap sectors have consistently outperformed. To gain access to that outperformance you would have needed to dial up your exposure to that part of the market, which is difficult to do with a purely index-led approach.

Flexibility is a double-edged sword: with greater capacity to outperform also comes greater scope for mistakes. But many active investors in UK equities seem to have made good use of their greater freedom. Indeed, performance has been so good that over the past three years, a UK fund manager has needed to generate an excess return of 5.7 per cent annualised (net of fees) to be in the top quartile of the IA UK All Companies sector.

This represents an astonishing degree of outperformance compared with continental Europe and the US, where the top quartile have outperformed by only 1.1 per cent and 0.2 per cent, respectively.

But why have UK fund managers found it so much easier to pick a portfolio that outperforms the market? The simple answer is that there have been more winning stocks to pick from. As the percentage of outperforming stocks has risen, so have the excess returns of the top quartile of UK funds.

This is almost entirely owing to the large declines in the value of oil and gas and mining companies. In effect, all that a UK fund manager has needed to do to significantly outperform the benchmark was to stay out of these sectors.

We may see the same pattern repeat itself in 2016. But the commodity bear market has been so long and so severe that a bottoming within the next 18 months seems more likely than not. That, in turn, would suggest an end to the severe underperformance of equities in these sectors – and the end of this easy route to outperformance.

Investors need to bear this in mind. Risk is a key consideration: competition has led some fund managers to take on more in the effort to keep up with the pack.

According to the IA, 28 per cent of active funds in the UK All Companies sector held 40 stocks or less in Q3. Depending on the stocks, this could leave investors highly vulnerable to unpredictable, idiosyncratic risks affecting individual companies.

With individual stock returns and valuations now more dispersed, and the level of analyst coverage for each company generally lower than in other markets, there is still plenty of scope for active managers to outperform in the next few years. But the past few years in the UK have been unusual, in that the consensus trade has also delivered great outperformance against the main equity benchmarks.

When the tide finally turns for commodities, this era will come to an end and the focus will shift back to the old-fashioned drivers of outperformance: research-driven individual stock views, portfolio construction and risk factor management. Some managers will handle the change of direction a lot better than others.

Stephanie Flanders is chief market strategist for Europe at JP Morgan Asset Management