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UK funds' underperformance is down to the old 'mid-cap bias'

Charles Younes

Charles Younes

Market commentators and investors had just begun to get accustomed to the new paradigm of a low growth and low inflation environment, only for opinions to start to change drastically in 2016.

Throughout the year new shoots of optimism sprouted across markets, as investors were buoyed by the uptick in oil prices and the apparent shift from monetary to fiscal stimuli. With the Trump bump adding further fuel to the reflation trade and an improvement in animal spirits, we thought it would be interesting to assess how UK equity managers have processed this new information. 

The obvious answer would be to say very badly. 

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In a year where value, as measured by the FTSE World Value United Kingdom index, has outperformed the FTSE All-Share index by 11 percentage points, the average UK equity manager has underperformed the main UK equity index by five.

Given market strength, it was unsurprising to see UK equity income managers also underperforming by 7 percentage points. Most of the underperformance was generated in the first half of 2016 when UK equity managers were caught by a double surprise: the Brexit vote and a rally in oil prices.  The average UK equity manager experienced a relative loss of 3.9 per cent in the three days around the EU referendum vote. 

Following this, it appears that many managers reacted to new information by re-adjusting their sector allocations. This was mainly highlighted by an increased allocation to the basic materials sector. Towards the end of 2015, the average allocation to this industry was 4.3 per cent. One year on, this number stands at 7.1 per cent. 

With the benchmark weight at 7.7 per cent, you can easily interpret their moves as an attempt to decrease their underweight to mining companies. This same play was replicated within the oil and gas sector, as average allocations increased from 5.8 per cent to 7.3 per cent (the benchmark weighting is 12.7 per cent). 

Did these tactical changes to the industry allocation able to generate good performance? Not really. While the value rally grew after the election of President Trump, the performance of the IA UK All Companies and IA UK Equity income sectors has not rebounded. R squared – a measure that shows the proportion of a fund’s movements attributable to its benchmark – confirms our first thought that this change to industry allocations has not affected the fund performance.

Even worse, it appears that a lesser percentage of the performance of the IA UK All Companies sector can be explained by the value factor. The R squared of this sector against the FTSE World Value index decreased from 0.75 to 0.05 on a rolling one-year period. Surprisingly, this measure also decreased when comparing the IA UK All Companies sector to the FTSE All-Share index and the growth factor.

If growth or value factors or the main UK equity benchmark cannot explain the performance of the IA UK All Companies sector, it must be size. Using the FTSE 250 index as a proxy for the mid-cap bias, it appears that 88 per cent of the performance of UK All Companies funds remains explained by the FTSE 250 index – a number that has been consistent over the past year. So managers slightly readjusted their portfolios to the reflation trade, but these moves were not enough to offset the main risk that investors remain exposed to when buying an active UK equity strategy: the mid-cap bias.