Are IA Equity sectors well defined?

Charles Younes

Charles Younes

After comprehensive consumer research and industry consultation, the Investment Association (IA), has decided to lower the yield requirement from 110 to 100 for funds in the UK Equity income sector.

The classification debate is highly important as most investors run their fund analysis by comparing funds to their sector peers.

The aim is for investors not to “compare apples and oranges”. To assess the validity of the current sector classification, I decided to use two measures of dispersion of returns: the standard deviation and the range between the first and third quartile. I decided to look at the one-year return for every IA equity sector over the last seven years. 

Looking at those results, it is interesting to note that the IA UK Equity income recorded the lowest dispersion of returns, as measured by the standard deviation; and second lowest as measured by the range of performance.

On average, the difference in performance between the 25th and 75th best performing funds in the sector was 12.11 per cent.

There were also periods, such as the second half of 2014 and first half of 2015, when the difference in performance was less than ten per cent, indicating a strong consistency in performance between UK Equity Income funds.

On the other hand, the IA UK Smaller Companies sector appears to bring together funds which have very dissimilar investment objectives. It might be because the underlying asset class (UK Smaller companies), is more volatile than others. Another reason could be that the sector can be split up into different sub-categories.

Our analysis of the sector highlights four main group of funds: funds using the Numis Smaller Companies and AIM indexes as the investable universe; others using the FTSE Small Cap (ex-Investment Trust) index or FTSE AIM or MSCI UK Small Cap. 

My analysis further highlights specific periods where the difference in performance between sector peers increased. This was indeed the case around June 2013, as well as in the fourth quarter of 2016. These periods correspond to the so-called “Fed tapering tantrum” and “Trump election” events.

Across all IA equity sectors, the range of performance between funds increased during these two events. Fund managers were relatively unprepared for these scenarios. Regarding the former event, asset managers were caught by the increase in correlation between bonds and equities, which fell together instead of moving in opposite directions as they normally do.

Regarding the latter, few polls predicted Trump would win the US election.

I think it is also important to link these events with the underperformance of active managers during these periods. After three years of momentum / growth-led equity markets from mid-2013 to mid- 2016, most fund managers had given up on value investing.

Only a few active managers maintained their exposure to the value factor, explaining the large difference in performance between active managers.