Take stock of election jitters

This year could turn out to be a pivotal one for the UK market. Already in Q1 we have seen the FTSE 100 Index reach an all-time high, surpassing a level last seen in the heady days of the technology bubble back in late 1999, and in the first week of May the UK electorate will go to the polls in what could be a defining election for the future of the UK.

To many, this may seem like an anomalous situation given that this election is looking like being the closest and most uncertain in the past 40 years. Unsurprisingly, this is creating challenges for anybody who allocates to UK equities, with key questions about how to play the market this year.

One of the main winning strategies for investors in the UK over the past 15 years has been to simply have an overweight position in mid-cap companies with the FTSE 250 ex-IT Index delivering enormous outperformance of the FTSE 100 Index. In fact, since ending a period of underperformance on 28 December 1998, the FTSE 250 ex-IT Index has outperformed the FTSE 100 Index by more than 200 per cent to the end of February 2015.

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This strategy is all well and good, but it clearly has not been without periods of volatility and pain. Essentially, investors following this approach have been running significant tracking error risk against the FTSE All Share Index, which at various times has caused painful periods of relative underperformance. As with any rotation in the stockmarket, these periods generally catch people by surprise and the movements are often sharp.

In the first part of 2014, the rotation from mid cap back to large cap caught many investors by surprise. The result was an underperformance of almost 10 per cent in just eight weeks. The proof of just how active managers were positioned was highlighted by looking at the best performers in the IA UK All Companies sector over this period. Perhaps surprisingly, five of the top 10 funds were FTSE 100 Index trackers, as active UK managers positioned themselves away from the largest companies in the UK.

While the lesson in history is interesting, looking forward is clearly more important. However, knowing what risk you are taking with your positioning is crucial. With the election causing a potential headache for UK investors, understanding how your exposure is likely to perform given various scenarios makes it far easier to understand and predict performance.

The challenge now is to determine how much active risk managers are prepared to take given the risk events that are ahead of the UK market. There is never much upside in trying to predict politics, and the difficulty this time round is that it is conceivable that every outcome bar a clear Conservative majority is potentially challenging for UK equities – and the odds on an outright Conservative majority are very small indeed. It would appear an almost certainty that the country will end up with either another coalition or minority government, with the latter looking ever more likely given the level of squabbling between the major parties.

Every likely outcome would appear to create some level of uncertainty, be it the prospect of the SNP as part of a coalition, a weak minority government that cannot get its policies through, or a Conservative government that pushes forward plans for an EU referendum. With markets near record highs, none of these political outcomes creates a business environment conducive to growth and confidence.