Are the tides turning for UK equities? - J.P. Morgan Asset Management

Are the tides turning for UK equities?

Contributor Alex Dryden
In brief
  • A falling pound and a stabilisation in commodity prices are changing the dynamics for UK equity investors. So far this year, only 21% of active fund managers have outperformed the FTSE All-Share Index, compared to 79% in 2015.1
  • Top decile UK fund managers in 2015 had, on average, a 75% allocation to mid and small cap stocks. To put this in perspective, the FTSE All Share has just a 20% weighting to mid and small cap.2
  • Given the potential for a turnaround in large cap stocks, investors should assess whether they are comfortable with taking on such a heavy overweight to mid and small cap stocks.3
Consensus trades have driven outperformance

Over the last decade, the UK equity investment landscape has been shaped by two major trends: the outperformance of small and mid cap stocks, and the underperformance of commodity sectors. The UK has been one of the fastest-growing economies in the G8, expanding by 2.1% a year over the last five years compared to a G8 average of just 1.5%. The relative strength of the UK economic recovery has driven significant outperformance in more domestically exposed mid and small cap equities vs. the internationally exposed large caps. From 2006 to 2015, the FTSE 250 has returned 12.7% on annualised basis. Small cap equities have also performed well, returning 7.8%. In comparison the FTSE 100 has delivered annualised performance of just 6.0% since 2006.

The second major trend that has driven market performance has been the underperformance of commodity-related companies since 2008. The boom caused by rapid urbanisation in China had seen the Bloomberg Commodity Index surge 160% from 2000 to 2008. Since then, a combination of oversupply and a drop in Chinese demand has triggering a protracted bear market. The index has fallen 70% since its peak in February 2008. Falling commodity prices have had a disproportionately large impact on the performance of UK large caps, as commodity-related names made up over 30% of the index in 2008. Today, their weighting has halved to just 16%.

Due to two major trends unique to UK equities, UK active fund managers have been able to significantly outperform the FTSE All-Share Index in recent years
Exhibit 1: Top quartile excess performance of active fund managers by region
Three-year rolling average

Source: Morningstar, J.P. Morgan Asset Management; data as of 18 May 2016.

Active UK equity fund managers have not been blind to these trends. As we highlighted in our recent paper, A fresh take on UK equities,3 over the last few years, UK active fund managers have adopted a consensus trade of underweighting commodity stocks and going heavily overweight small and mid cap companies. As highlighted in Exhibit 1, this has helped the top quartile of active managers to outperform the benchmark by approximately 6% on an annualised basis over the last three years, considerably more than their US and European peers.

These consensus trades have dominated the UK equity fund investment landscape over the past decade. In Exhibit 2, we highlight the extremes of positioning that have driven the outperformance. The best-performing 10% of UK active fund managers have, on average, a 75% allocation to the small and mid cap stocks and just a 7% weighting to commodities.4 To put this in perspective, the benchmark has a 20% weighting to small and mid cap stocks and a 16% exposure to commodity sectors.

Signs of turning tides

There are now signs that the tides are beginning to turn in these trends that have been profitable for the top-performing UK equity fund managers. The catalysts for change are a potential bottom in the commodities market, a weaker pound and stretched relative valuations.

A consensus position for UK active managers has been to overweight UK small and mid cap and underweight commodities. Some of the top managers have taken this trade to extremes
Exhibit 2: Portfolio exposure of UK active fund managers in 2015 to selected sectors, broken down by percentile
Smoothed across five percentile moving average

Source: Morningstar, J.P. Morgan Asset Management; data as of 18 May 2016.

After eight years of consecutive declines, commodity markets are finally showing signs of approaching a bottom. Much of the rebound has been triggered by significant supply cuts; the oil and gas industry, for example, implemented USD 380 billion of capital expenditure cuts between the summer of 2014 and the end of 2015. These supply cuts have helped the Bloomberg Commodity Index rally 8% so far in 2016.

A turnaround in the commodity market could have wide ramifications for asset allocation, particularly in UK equities. As commodity prices have rallied, materials and energy have been the top performing UK equity sectors in 2016. Although price volatility continues, commodities outperformance presents a challenge to many of the best-performing fund managers, given their long-held underweights in the sectors.

For the last three years, the strength of sterling has been a headache for large cap UK companies, which source approximately 75% of their earnings overseas. A weaker pound could therefore also herald a change of dynamics in the UK equity space. Sterling has weakened 8% on a trade weighted basis since August 2015, as uncertainty over the outcome of the EU referendum has taken its toll. In the event that the UK votes to remain in the EU, it is unlikely that sterling will return to previous highs immediately, given the country’s still-significant current account deficit of well over 4% of GDP. A third factor that could trigger a change in the UK equity market is the relative valuation of small and mid cap stocks vs. large caps. As we highlight in Exhibit 3, the outperformance of small and mid cap companies since the financial crisis has pushed relative valuations to stretched levels. Investors should be mindful of the growing potential for a reversal.

Valuations of UK mid and small cap equities compared to large cap have reached stretched levels
Exhibit 3: Relative price-to-book ratio of large cap equities versus mid and small cap equities

Source: FactSet, FTSE, J.P. Morgan Asset Management. Large cap equities is the FTSE 100, mid cap equities is FTSE 250 and small cap equities is FTSE SmallCap Index. Data as of 18 May 2016.

The changes in market leadership so far this year have caught many active fund managers off-guard. In 2015, 79% of active fund managers were able to outperform the FTSE All Share. In 2016 to date, only 21% of managers have outperformed the benchmark as the stronger pound, rebounding commodities and stretched valuations have weighed on performance. The top decile of fund managers in 2015 are registering some of the worst performance in 2016. Those managers who were in the top decile in 2015 are now on average 79th percentile over the year to date. Meanwhile, managers who held positions that were out of favour last year, such as overweights in commodities and large cap, are experiencing some of the best performance: those who are in the top decile year to date were, on average, in the 82nd percentile in 2015.5

Hurdles to positioning for change

The potential for a change in the tides presents challenges for UK fund managers who have taken advantage of the trends driving markets over the last decade. In theory, managers should be able to reallocate away from mid and small cap sectors and towards large caps in anticipation of the change. However, we believe there are two hurdles that may delay this change: the willingness and the ability of managers to change tack.

Certain parts of the UK equity space are highly illiquid. This can lead to pricing pressures if everyone tries to exit the market at the same time
Exhibit 4: Total value of trading in 2015 in selected markets
GBP trillions

Source: Goldman Sachs, J.P. Morgan Asset Management; data as of 18 May 2016.

A manager whose results have been driven by mid and small cap outperformance is likely to feel attached to this positioning and reluctant to change. Large cap equities have underperformed mid and small caps in four of the last five years. Some fund managers may be reluctant to call time on these trends. This behavioral bias could mean that managers hold onto their mid and small cap positions longer than is optimal.

Even if managers are willing to change, implementing that change might not be straightforward. Many UK fund managers have spent nearly a decade building up their small and mid cap allocations. Unwinding these positions in the relatively illiquid small and mid cap parts of the market is likely to be challenging. As we highlight in Exhibit 4, the value of trades on the FTSE Small Cap and FTSE 250 combined was just £0.16 trillion in 2015, not even a fifth of the value of trading in FTSE 100 stocks. In such an illiquid market, not only will a rotation take a significant amount of time, but it could do significant damage to fund profitability. If a large number of managers are trying to rotate out of mid and small cap stocks and into large cap at the same time, the market is unlikely to absorb all of the selling pressure. This liquidity issue may create a race for the exit, as managers cut prices to attract buyers, further damaging overall fund performance.

Investment implications
  • A change in the tides, driven by the bottoming of commodity prices, a weaker pound and relatively stretched valuations, poses challenges for active UK equity fund managers and investors. In theory, fund managers should be able to adapt; however, behavioural and practical obstacles mean a rotation in market leadership could hit fund performance and drive up market volatility.
  • A key risk to our argument is that we may be too early in calling the end of the commodity bear market. While we acknowledge the difficulty with calling the end of a near decade-long trend, investors should still assess whether they are comfortable with top active fund managers having a 75% exposure to UK mid and small cap equities. Even the slight trimming of this exposure today could help with performance further down the line.
  • This piece poses a number of key questions for UK equity investors: do you believe the trends that have driven UK equity market performance are approaching their end? Are you comfortable with the significant mid and small cap bias that many of the best-performing UK fund managers are holding? Is it time to think about making a change in your UK equity allocation?

1Source: Morningstar, data as of 18 May 2016.

2Source: Morningstar, data as of 18 May 2016.

3A fresh take on UK equities, Stephanie Flanders, David Stubbs and Alex Dryden, J.P. Morgan Asset Management, November 2015.

4Source: Morningstar, data as of 18 May 2016.

5Source: Morningstar, data as of 18 May 2016.

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