Not long ago, the IMA issued a statement saying that it declined to narrow its much maligned UK All Companies Sector. That’s more than a little odd: The sector is extremely broad, and is thus a poor basis for comparing all but the most flexible funds. The only common feature of the funds in the sector is that they invest at least 80% of their assets in UK equities. Beyond that, there is wide disparity of investment style: ACM Bernstein UK Value, a large-cap, value-oriented offering, is mixed in with mid-cap funds such as Allianz RCM UK Mid-Cap, and FTSE 100 trackers rub shoulders with FTSE 250 trackers.
More Precision Needed
So, how to sort through this morass? The best answer, we think, is to use narrower sectors such as our Morningstar categories. We place a fund into its category based on its average portfolio positioning over the past three years. To do this, we look through to a fund’s complete portfolio holdings over the period. Thus, if a manager has been invested mostly in cheap, large-cap UK equities over the past three years, the fund will land in our UK Large-Cap Value Equity category. If the manager has invested mostly in mid-caps, or in a mix of capitalisations that average out to mid-cap, the fund will be placed in our UK Mid-Cap Equity category.
The sharper focus is a good tool for evaluating fund managers. If you want to know if a manager who has focused on mid-cap equities has added value, you don’t look at him relative to the wide range of offerings included in the IMA sector. This would only tell you the degree to which mid-cap equities have outperformed or underperformed large-cap and small-cap equities. Instead, you need to look at the fund relative to other UK equity funds with similar market cap exposures. This is why we award our star-ratings based on a fund’s risk-adjusted performance relative to its Morningstar category peers.
Don’t Buy the Past
One of the biggest mistakes investors make is to focus their efforts primarily on funds that have performed well in the past. Past performance can be a useful indicator of a manager’s skill level, but it’s only a starting point. It is much more important to ask how the performance was generated and whether or not is likely to be repeatable in the future. There are many factors that need to be assessed to determine the latter, including continuity of management, changes in style and strategy, costs, how the fund has behaved during different sets of market conditions, and whether the current portfolio suggests one can reasonably infer the pattern will continue (we’ll shortly begin providing qualitative research to help investors do this).
In the case of the UK All Companies Sector, funds with significant large-cap exposure have badly underperformed their IMA sector rivals. On average, the top performing quartile of funds in the sector over the three years ended 30 September had the following market-cap exposures during the period: 24% large-cap, 34% mid-cap, and 42% small-cap. In contrast, the bottom-quartile of funds over the same period had 60% in large-caps, 20% in mid-caps, and 20% in small caps.
This is not surprising. Small-cap equities have significantly outperformed large-equities in many of the world’s largest since 2000, and going small has been an easy way for managers to outperform their benchmarks. The question at this point is whether or not the pattern is likely to continue.
Looking to the Future: The Case for Large Caps
By historical standards, the valuation levels of small-cap stocks looks stretched. In many markets, small-caps now trade at levels equivalent to or slightly richer than large-caps. Typically, large-caps have commanded a premium over small caps due in part to their greater liquidity, and in part to their generally lower level of volatility. Unless something has fundamentally changed in the market, it thus seems questionable to assume that small caps will continue to outperform.
With that in mind, we’ve screened the UK All Companies Sector for equity funds that devote more than 65% of their equity assets to large-caps, have a three-year return in the top-quartile of their Morningstar peer group, less than 15% in energy equities, and manager tenures of three years or longer. The following offerings met our screens.
| Better Than They Look? | |||
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Fund Name |
Morningstar |
Large-Cap |
5-Yr Rtn. |
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| Lazard UK Alpha |
UK Eq. Large Blend |
70 |
10 | JPM UK Active 350 A Acc |
UK Eq. Large Blend |
70 |
12 |
| Baillie Gifford British 350 C Acc |
UK Eq. Large Blend |
77 |
16 |
| Cazenove UK Opportunities A Acc |
UK Eq. Large Blend |
71 |
16 |
| Martin Currie UK Growth A Acc |
UK Eq. Large Blend |
80 |
17 |
| Rensburg Blue Chip Growth Inc |
UK Eq. Large Blend |
88 |
21 |
| L&G Ethical Trust(R) |
UK Eq. Large Blend |
68 |
24 |
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| Return data as of 30 September 2006 | |||
Among these, Rensburg Blue Chip Growth is the purest large-cap fund that isn’t a tracker. It’s also underweight in energy, which is unusual among funds focused on big UK companies. With Colin Morton at them since 2000, it’s had reasonable management stability—and we believe that the firm’s base in Leeds should help insulate it from the rapid manager turnover that plagues many firms in the City. Investors considering any of these funds should note that some are relatively concentrated—the Rensburg offering packed 46% of assets into its top 10 holdings as of 30 September, while the Baillie Gifford fund had just over 50% in its top 10 as of 30 June.
