- Domestic equities play a key role in most UK investors’ portfolios, accounting for 27 per cent of their holdings on average1.
- The UK macro environment is favourable, with decent economic growth and the consumer looking stronger. But the peculiarities of the main UK benchmark indices make it more difficult for investors to tap into the domestic recovery than in other markets.
- The unusual structure of the market has made it relatively easy for UK fund managers to outperform in recent years. They merely had to avoid energy-related stock and miners.
- We do not expect this pattern to last forever. As stock selection becomes more challenging, risk management could emerge as a key differentiating factor for UK funds.
How to profit from the UK economic recovery?
Domestic equities have long been the most important asset in UK investors’ portfolios, and there is little sign of that changing, with gross flows of GBP 36 billion into UK equity funds so far in 20152. In our last Market Bulletin, Are UK equities worth a closer look? , we put forward the case for an allocation to the UK equity market to benefit from the economic recovery taking hold in the country. But the structure of the UK market, and especially of its benchmark index, can make it difficult to put this advice into practice.
Investors who are tracking the FTSE 100 will see their play on the UK economic recovery drowned out by the global nature of the FTSE 100’s earnings – exposure that comes largely from its mega cap miners, energy and financial stocks. This is not very surprising when we consider that the companies that make up the FTSE 100 obtain only around 20% of their revenues from the UK economy, on average (Exhibit 1).
EXHIBIT 1: AVERAGE PERCENTAGE OF REVENUE SOURCED FROM THE UK
Source: Citi, J.P. Morgan Asset Management. *Excluding Investment Trusts. Data as of 25 November 2015.
As Exhibit 1 also demonstrates, the companies in the FTSE 250 and FTSE Small Cap source a much higher proportion of their revenues from the UK. In comparison, the FTSE 100, due to its global rather than domestic focus, sources less of its revenues from the UK. This also has an impact of the FTSE All-Share as FTSE 100 companies account for around 80 per cent of the market value of the All-Share.
As Exhibit 2 shows, this degree of market concentration is highly unusual. The top 25 per cent of stocks, ranked by size, account for a much larger share of the UK index than of the other major developed market equity indices.
EXHIBIT 2: CONCENTRATION OF LARGEST QUARTILE OF STOCKS
Percentage of overall market cap
Source: FactSet, J.P. Morgan Asset Management. UK is FTSE All-Share, US is S&P 500, Emerging markets is MSCI EM and Europe is Stoxx 600. Data as of 25 November 2015.
The concentration to large cap equities in the FTSE All-Share has also weighed on long run performance. Exhibit 3 compares the performance of an equally weighted version of the FTSE All-Share Index to the FTSE All-Share Index and FTSE 250 Index over the last 15 years. The equally weighted index has significantly outperformed the official indices because small and mid cap companies have done much better overall than the large cap businesses that make up such a large proportion of the benchmarks.
This pattern could change in future; investors do not necessarily want to be betting perpetually on UK mid and small cap companies. The point is rather that investors should have flexibilitythe to dial up and down their exposure to small and mid cap companies when appropriate. The structure of the UK benchmark indices makes this very difficult to achieve using a narrow, index-based investment approach.
EXHIBIT 3: UK EQUITY PERFORMANCE
Rebased to 100 as of January 2001
Source: FTSE, FactSet, J.P. Morgan Asset Management. *The FTSE All-Share evenly weighted index does not include companies that have joined the index since 2001. Rebalancing occurs monthly. Data as of 25 November 2015.
Large outperformance for top quartile performance in the UK…unlike other regions
Many active managers in the UK equity sector have taken full advantage of that flexibility in recent years. In fact, performance has been so good in this sector over the past three years that a UK fund manager has needed to generate an excess return of 5.7 per cent annualised (net of fees) to be in the top quartile (UK IA All Companies). This represents an astonishing degree of outperformance when compared with continental Europe and the US, where the top quartile have outperformed by only 1.1 per cent and 0.2 per cent, respectively3.
Exhibit 4 shows how the excess returns of the top quartile funds have varied over time in these three key markets. Though the absolute numbers for Europe are much lower, in both the UK and Europe the current level of outperformance matches previous highs seen in 2002. But the situation in the US today is very different from the early 2000s, with little in the way of excess return needed to make it into the top quartile of funds.
EXHIBIT 4: TOP QUARTILE EXCESS PERFORMANCE BY REGION
Source: Lipper, MorningStar, J.P. Morgan Asset Management; data as of 25 November 2015.
This extreme degree of outperformance in the UK has been driven by funds finding it easier to outperform their benchmark, month by month. A measure of that monthly outperformance – known as the batting average4 – turns out to be highly correlated with excess performance over the period (Exhibit 5).
EXHIBIT 5: TOP QUARTILE UK EQUITY FUND: EXCESS RETURN VERSUS BATTING AVERAGE
Source: Lipper, MorningStar, J.P. Morgan Asset Management; data as of 25 November 2015.
This explains, mechanically, why excess returns have been so high. It does not explain why fund managers have found it so much easier to pick a portfolio that outperforms the market than in the past. However, Exhibit 6 reveals the answer: there have simply been more “winning” stocks for managers to pick. The percentage of outperforming stocks has risen, alongside the excess returns of the top quartile of UK funds. This is almost entirely due to the large declines in the value of oil & gas and mining companies, which between them accounted for 29 per cent of the FTSE All-Share in 2011, but now account for just 17%. In effect, all that a UK fund manager has needed to do to significantly outperform the benchmark is stay out of these sectors. For example, a manager who zero-weighted the mining sector at the start of 2015 would have garnered a 2.5 per cent outperformance versus the index with just that one decision, in a year in which the sector fell by 40 per cent. The negativity around commodities made this a relatively consensus call and many managers did just that.
EXHIBIT 6: TOP QUARTILE UK EQUITY FUND: EXCESS RETURN VERSUS PERCENTAGE OF INDEX CONSTITUENTS OUTPERFORMING
Source: Bloomberg, Lipper, Morningstar, J.P. Morgan Asset Management; data as of 25 November 2015.
The commodity bear market is severe, and sentiment is currently very poor, but it seems plausible that we are closer to the end than the beginning. From the trough in February 1999, the Bloomberg commodity index rallied 214% to its peak in June 2008 before plunging during the Great Recession. The large falls during the crisis initially reversed, but then prices rolled over and are currently 65% lower than they were at the peak.
It may be too soon to call the end of the downturn, but a bottoming within the next 18 months seems more likely than not. That, in turn, would suggest an end to the severe underperformance of equities in these sectors, though there could be longer-term side effects in the form of weakened balance sheets and reduced dividends.
Opportunities for outperformance going forward:
A) Sector valuation dispersion
Exhibit 7 shows how the carnage in the oil, gas and mining stocks has increased the level of dispersion in sector valuations in the UK market. The commodity slowdown has badly damaged valuations in energy and mining companies in the FTSE All-Share, many of which sit in the large cap space – which in turn explains some of the underperformance of large cap UK equities in recent quarters.
By comparison, the relative strength of the UK consumer has pushed up valuations in consumer-oriented sectors. But the last 10 years have been rocky ones for consumer stocks, and perhaps do not offer a fair basis for comparison. With real wages growing and unemployment falling in the UK economy, there could be additional upside in cyclically oriented sectors.
EXHIBIT 7: UK EQUITY VALUATION SECTOR DISPERSION
Source: FactSet, J.P. Morgan Asset Management; data as of 25 November 2015.
B) Lack of analyst coverage
Another factor that highlights the potential for outperformance by active UK equity managers is the large proportion of the asset class that has a low level of analyst coverage. As Exhibit 8 shows, more than 50 per cent of the companies in the FTSE All-Share are covered by five or fewer analysts. The typical company in the US or continental Europe will have more extensive coverage. This should allow active managers to exploit informational inefficiencies in share prices, providing scope for greater outperformance. Of course, whether individual managers achieve this outperformance going forward is another matter.
EXHIBIT 8: BREAKDOWN OF ANALYST COVERAGE
Source: FactSet, J.P. Morgan Asset Management. The values for the FTSE All Share include listed investment trusts; when excluding these, the values change to 9% coverage of 0 to 1 analysts, 16% for 2 to 5 analysts and 74% for 6+. Data as of 25 November 2015.
Risk as a differentiating feature
There is a final aspect to investing in UK equities that investors need to consider especially carefully in the current environment: risk. That is because the pressure of competition in the UK market has led some fund managers to take on more risk in the effort to keep up with the pack. Investors will have differing attitudes to risk, depending on the nature of the investment and where it fits in their portfolio. But to choose appropriately, they must first understand the risks involved in a given approach. In the UK market, these are not always obvious.
- 28 per cent of active funds in the Investment Association (IA) UK ALL Companies sector held 40 stocks or fewer in the third quarter of 2015. Depending on the stocks, this could leave investors highly vulnerable to unpredictable, idiosyncratic risks affecting individual companies5.
- 20 per cent of active funds in the IA UK ALL Companies category have more than 10 per cent of their assets under management (AUM) in non-UK stocks. Many investors might be surprised to hear that UK funds can hold up to 20 per cent of AUM in stocks listed outside the UK and still be categorised as UK funds6.
- The average three-year annualised tracking error of UK fund managers in the first quartile is currently 5.3.6 That compares with only 3.2 in the US. Such a high level of risk-taking may not be suitable for every investor’s portfolio.
If risk controls have been poor, then any reversal in the strong pattern of commodity and mining weakness and mid cap outperformance we have seen in recent years in the UK could catch some fund managers badly offside.
The past few years in the UK have been unusual, in that the consensus trade has also delivered great outperformance. When the tide turns on commodities, this era will come to an end and the focus will shift back to traditional drivers of outperformance: research-driven individual stock views, portfolio construction and risk factor management. Some managers will handle the change of direction a lot better than others.
Investment implications and considerations
- Investors are right to try to gain exposure to the domestic UK economic recovery. However, this is easier said than done, as UK equity indices have a significant exposure to large cap equities that source very little of their revenue from the UK.
- Investors looking to invest in UK equities should ensure they have the flexibility to increase their exposure to small cap and mid cap UK equities, which typically have a greater exposure to the real UK economic recovery.
- Recent years have seen many fund managers outperform the index by a wide margin, thanks to more stocks than usual beating an index that was dragged lower by a number of large, commodity-related stocks.
- The combination of wide valuation dispersions and little analyst coverage should provide a fertile ground for further outperformance by research-driven managers.
- However, investors should beware the risks currently been taken by many managers in the space, many of whom have benefited from a longstanding pattern of performance that may not have a lot more time to run.
1Source: UK IA sectors as a percentage of UK funds market, Broadridge FundFile, September 2015.
2Source: Investment Association, September 2015.
3Numbers are taken from the Europe LC Blend (continental European market) and US LC Blend (US mutual funds).
4Formally, “Batting Average” is a measure of a manager's ability to consistently beat the market. It is calculated by dividing the number of months in which the manager beat or matched an index by the total number of months in the period. For example, a manager who meets or outperforms the market every month in a given period would have a batting average of 100. A manager who beats the market half of the time would have a batting average of 50.
5 Source: Morningstar, September 2015
6Source: Morningstar, September 2015. Tracking error is a measure of the volatility of excess returns relative to a benchmark.
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The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future.