In a recent article, we demonstrated that UK equity active fund managers have largely benefited from a size bias in order to outperform the FTSE All-Share index.
They significantly allocated to members of the FTSE 250 index as it would give them more direct exposure to the domestic UK economy, which was growing at a faster pace than the overseas markets. To justify their market cap allocation, active managers also claimed that UK mid-caps offered a higher opportunity to add value through stockpicking. But has this really been the case?
Market opportunity can be measured by the dispersion of stock returns within an index. Using the FTSE 100 as a proxy for large caps and the FTSE 250 for mid caps, our analysis shows this has been the case, at least for the past five years, with return dispersion in the small-cap index higher than the large cap.
Since 2011, on average the top-50 performers of the FTSE 100 index have outperformed their benchmark by 16.8 per cent; conversely, the bottom-50 stocks have lagged the index by 15.7 per cent. In other words, the dispersion between the top and bottom 50 stands at around 32.4 per cent over the past five years.
Investors should be careful if a mid-cap fund manager holds more than 100 names in the portfolioCharles YounesThese numbers significantly increased for the FTSE 250 index with the dispersion in relative returns between the top and the bottom 50 being twice as big at 68.2 per cent. It is also interesting to see that this dispersion number is skewed to the upside for the FTSE 250, contrary to the large-cap index. On average, top-50 stocks in the FTSE 250 have outperformed the benchmark by 40.9 per cent over recent years. Conversely, bottom-50 stocks have underperformed by 27.3 per cent.
Therefore, a UK equity active fund manager should have put more money into the mid-cap index as its relative downside was limited while its relative upside was much higher.
We went further, and our analysis into portfolio construction also showed it was key to outperformance.
We found the dispersion of returns from stocks decreased dramatically as the number of grouped holdings increased. This means the dispersion between the top-10 and the bottom-10 stocks was twice as great as that when using the top and bottom 25. Similarly, this halved again when comparing the top and bottom 50 stocks. So, probably, a good number of holdings for a mid-cap manager is around 50.
Investors should, therefore, be careful if a mid-cap fund manager holds more than 100 names in the portfolio – probably the portfolio is too diluted and the manager is just playing the average number game, trying to have a gain/loss ratio above 50 per cent, rather than trying to maximise the excess return.
UK equity active fund managers did well to invest more heavily in the mid-cap market over recent years. There were economic fundamental reasons to back their decision along with higher market opportunity. Not only did the FTSE 250 outperform the FTSE 100, but the average gain for investing in a top-performing stock in the mid-cap index was higher than the average loss for investing in an underperforming stock.
Although there was higher market opportunity within the FTSE 250, it does not mean that all fund managers were able to capture it. While stockpicking is a good tool, portfolio construction is another powerful instrument that is often neglected.
Charles Younes is research manager at FE
