At first glance you might think this is yet another article comparing the net performance (after fees) of active managers with passively managed funds.
This article, however, will not be detailing the advantages or the disadvantages of either strategy. We believe that recent developments in the investment industry should motivate UK equity investors to combine both approaches.
Two sets of data, relating to funds’ tracking error and r-squared measure, have caught our attention over the past 12 months. The tracking error is an indication of ‘riskiness’ in a manager’s investment style, while the r-squared gives an assessment on how much of the fund’s performance can be explained by its benchmark. We calculated these ratios for the IA UK All Companies sector against the FTSE 100 and FTSE 250 indices.
Historically, the performance of a typical UK equity fund manager, as represented by the average performance of the IA UK All Companies sector, is more closely related to the FTSE 100 (large cap) than to the FTSE 250 (mid cap), as highlighted by these two measures. However, the current tracking error and r-squared measures indicate this relationship has broken down since the second half of 2015. In other words, a typical UK equity manager currently behaves much more like a mid-cap equity manager than a large-cap equity manager.
This change makes sense if you take into consideration the strength of the domestic UK economy relative to international markets over the past four years. Active UK equity managers have tried to outperform their benchmarks by selecting companies that would give them direct exposure to the domestic economy. Revenues from domestic companies in the FTSE 250 are higher than in the FTSE 100, which is more internationally focused.
This trade proved to be a good decision, as the FTSE 250 has outperformed the FTSE 100 over the past four calendar years. In 2015 the average performance for the IA UK All Companies sector was 4.9 per cent, against 0.8 per cent for the FTSE All-Share index.
We also calculated the alpha generation of the IA UK All Companies sector, the top active UK equity funds and the FTSE 250 against the All-Share over the past three years. It is interesting to note that the correlation between the alpha of IA UK All Companies and the mid-cap index is above 0.9. In other words, more than 90 per cent of the outperformance of active UK equity fund managers can be explained by their preference for UK mid caps over large caps.
But the EU referendum vote has since shuffled this deck, with the weakness in sterling acting as a catalyst for companies generating their revenue overseas to be rewarded on the upside. As a result, the large-cap index has outperformed its mid-cap peer by more than 10 per cent this year. Unsurprisingly, the average performance of a UK equity fund manager has been below the benchmark. Relative losses could have been mitigated by diversifying the source of alpha, such as by investing in a FTSE 100 tracker.
Investors should not view active and passive investments as two conflicting forces. It can actually help to combine both approaches, as long as investors understand and diversify their sources of alpha. A passive investment could offer cheaper access – something worth considering, especially if all active managers are positioned in the same crowded trade.
Charles Younes is research manager at FE
