In spite of the apparent calm in the UK equity market this year at the headline level, there has been much turbulence beneath the surface in the past couple of months.
While overall volatility has been at very depressed levels, movements between styles and market capitalisation bands have been dramatic. There have been two key manifestations of this: a rotation out of growth stocks, such as tech hardware and mobile telcos; and a move into more defensive stocks, such as tobacco and pharmaceuticals.
The most extreme performance difference between these this quarter is almost 20 percentage points. The other rapid shift has been between mid-cap stocks, as represented by the FTSE 250 index, and large-cap stocks, as represented by the FTSE 100 index. The difference between these indices in just the past three months is more than 6 per cent in favour of the larger names.
These moves have had a noticeable impact on the performance of UK equity managers relative to the index. For example, the IMA UK All Companies sector is essentially flat in the past three months alone, whereas the FTSE All-Share index is up more than 3 per cent.
Our managers have had mixed results, and we are actively considering whether we need to revisit or reweigh our blend of funds in order to be better positioned for the future environment.
Axa Framlington UK Select Opportunities, for example, is down just more than 2 per cent in the past three months, while GVO UK Focus is up more than 4 per cent.
Active managers in the UK have a perennial bias away from the largest stocks and towards mid caps. This is not only because of the Ucits 5/10/40 rule, but also because managers want to diversify their portfolios more than is the case when the likes of HSBC, BP and Shell each constitute more than 5 per cent of the FTSE 100 index.
Managers also find more inefficiencies, less ‘schooled’ executives and less broker coverage outside the largest stocks. Nevertheless, we may want to tilt into managers who have less of an underweight to large-cap stocks if this is only the start of a price correction.
A look at the current valuations of large caps versus mid caps reveals that while the FTSE 250 index is on a forecast price-to-earnings (p/e) ratio of 15.7x and the FTSE 100 index is on 14x, such a premium is well within the historic range of up to a 20 per cent premium.
It is often said that mid-cap stocks deserve a premium due to their superior earnings growth over time because they are more nimble and smaller. This is supported by the fact the following year’s forecast p/e ratios are almost identical, at 13.8x and 13x respectively.
Mid caps tend to be more exposed to domestic economic factors than their larger brethren, and so there are concerns that, as the start of the rising rate cycle appears likely to be this year, the earnings of mid caps will be affected more than those of large caps.
The message is clear, though, that interest rate rises will be slow and measured. On balance, while trimming some of the tilt among managers away from large-cap equities may be prudent, a wholesale reweighting seems unnecessary.
Ian Aylward is head of multi-manager research at Aviva Investors
