EquitiesSep 19 2016

Step back from the headlines on Brexit

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Large caps have underperformed in the second half of this year – you heard it here first. The market has been so focused on what’s happened since the Brexit vote on June 23 that it’s missed the bigger picture since the start of July. More of which later.

The immediate referendum aftermath saw sterling plummet, a sell-off in domestic stocks and a rally in dollar-earning, internationally focused large caps.

In June, this meant mid caps – as measured by the FTSE 250 index – had their worst ever month relative to the FTSE 100. June was also the third-worst month for the FTSE Small Cap index relative to the blue-chip index.

This dynamic has meant headlines championing investing in mega caps with international earnings. On the face of it, this thesis has a strong foundation.

With sterling weakening, avoiding UK plc and backing firms where the majority of revenue comes from abroad keeps investors away from domestic uncertainty.

When sentiment is so negative it’s uncomfortable to be a contrarianJonathan Miller, Morningstar

This sharp swing comes after years of outperformance for mid and small caps, which had already been underperforming since the start of 2016. The area has been a sweet spot for active fund managers.

Morningstar gathers all the portfolio holdings of active funds, and when these are aggregated for its UK Flex-Cap Equity sector, about half the exposure is in large caps. The other half is spread across mid and small caps.

Given this dynamic, and the fact that around 80 per cent of the FTSE All-Share index is made up of large caps, active managers have struggled in the first half of the year. The FTSE 100 gained 6.1 per cent, mid caps dropped 5.7 per cent and the UK Flex-Cap Equity sector fell 4.7 per cent.

The uncertainty following the referendum caused a rapid, negative spiral in risk appetite, and a number of surveys in July showed sharp contractions. The tone of headlines on this side included, “crush the nation’s economy” and “terrifying charts”. When sentiment is so negative it’s uncomfortable to be a contrarian.

However, when you dig into the numbers, the large cap surge took place during a matter of days following the vote. Subsequently, from July 1 to the time of writing (September 9), it’s a different story. Morningstar’s UK Flex-Cap Equity sector rallied 11.7 per cent, mid caps gained 10.6 per cent and the FTSE 100 index was only up 5.2 per cent.

So mid caps, as well as small caps, have bounced back in the second half of the year. This sharp reversal has also seen active managers outperform the FTSE All-Share index by 5.5 percentage points.

There are of course many ways to slice data. And for clarity, when you bring these two time periods together, active managers are up 6.4 per cent year to date versus a gain of 10.2 per cent for the FTSE All-Share.

But the point here is that if you listened to the herd and made your move a few days after the vote, your switch into large caps has meant you’ve underperformed.

This isn’t a call to pile into mid caps. This is a call to take a step back from the headlines and see where investment opportunities have opened up. Uncertainty is still there, but we can also look to where the smart money has been going.

Many of the active UK equity managers positively rated by Morningstar have selectively topped up mid-cap exposure. There’s been no broad move into large caps. If anything, some managers have taken profits.

Jonathan Miller is UK director of manager research at Morningstar