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How DFMs played the UK equity bounce; Fundamental flaws dog rotation hopes

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Where the heart is

With the UK economy now officially in a transition period post (or pre, if you prefer) EU departure, domestic economic attention has temporarily turned to the Budget due on March 11. And while there are still concerns about the end of the Brexit transition period - and the government’s ability to deliver an expansionary package of economic measures next month - most investors agree some of the fog has lifted from the UK equity market.

After years of uncertainty, most global investors were structurally underweight the UK. DFMs, too, had increasingly sought out other pastures. But partial clarity was provided by December’s election outcome, which helped small and mid-caps rally into the end of the year.

Some discretionaries joined in that rally in December - but, perhaps surprisingly, they remained in the minority. As the chart below shows, our analysis of more than 40 wealth managers shows that two thirds kept their UK weightings static in the fourth quarter of last year.

This figure doesn’t quite tell the whole story - seven per cent of discretionaries changed their underlying UK fund selections without adjusting overall allocations, in addition to the quarter who upped weightings. But there was little consensus on how exactly to play the UK bounce. 

The majority of those who did turn positive did so either in the aftermath of the election, or as they gained confidence in the result. That inevitably meant looking to small and mid-caps. But opinion was split on whether this was a time for passive or active exposure. 

Some wealth managers went for the simple - and perhaps short-term - option of a FTSE 250 ETF. Others bought into the most popular, tried and tested active strategies already favoured by their peers. Most notably, more than one buyer opted for UK equity income strategies with a preference for smaller stocks. That degree of prudence is arguably reflective of the market as a whole: happy to embrace the good news in the short term, but still conscious of the lingering worries mentioned above. 

Fundamental flaws

The renewed drop in government bond yields seen at the end of January, driven by coronavirus concerns, meant it’s all gone a bit quiet again for value investing advocates.

Value stocks have tended to move inversely to US Treasury prices for some time now, which means every moment of panic tends to result in another setback for those hoping for a market rotation. From this vantage point, value’s big return to favour last September is starting to look like another flash in the pan.

To add to this, there are those who say there’s no reason why a rotation should take place. A year ago we discussed Credit Suisse research implying value shares' long period out of favour doesn't mean that a rebound is any nearer. And fundamentals aren’t suggesting undue neglect, either.

In the US, for example, earnings per share growth for value indices’ biggest stocks is, in aggregate, well below that achieved by typical ‘growth’ shares over the past few years.

That implies that it’s not just the market pushing up the latter at the expense of the former. Some of these companies are ‘value’ for a reason: in many cases earnings have been consistently disappointing.

This isn’t quite the same argument as saying the growth versus value equation has been superseded by the need to identify disruptors and new technologies. But it does suggest value advocates need fundamentals to improve as much as shift in market sentiment.

By the book

The FCA’s latest in its new series of ‘portfolio strategy’ letters, this time focusing on platforms, begins by reiterating the point we made earlier this week. It's warned that replatforming programmes are among the chief risks facing the sector this year, and indicated it will be watching closely.

The letter follows those addressed to asset managers and financial advisers, as well as alternative investment firms. At this point, wealth managers look conspicuous by their absence. But firms should allow for the fact that many businesses will fall into one of these other categories - and then remember that a similar letter was sent to their peers last summer.

That missive was arguably less critical than the issues identified in this year's notes to other sectors. But the regulator’s focus on suitability, costs and charges and liquidity means there are plenty of issues on the agenda that are of major relevance to DFMs. And as the wealth industry continues to carve out its own niche compared with advisers and fund firms, it’s unlikely to continue slipping through the cracks from the watchdog’s perspective, either.

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