It’s very clear that the UK economy is struggling right now, but thankfully it’s not all doom and gloom for investors. Markets have been tumultuous since the credit crisis gripped the global economy, but UK equity returns have been quite strong. Despite the fears of a double-dip recession, crippling sovereign debt, natural disasters, banking scandals and changes in political leadership, the FTSE All-Share returned an annualised 12% between 1 November 2008 and 31 July 2012. Even if we assume inflation was at its peak rate of 5.2% over the whole period, real equity returns would still have been in line with their long run, inflation-adjusted average. While that assumption is rudimentary, it still highlights the fact that UK equity market returns have not been as dire as recent headlines might lead us to believe. Indeed, academic research suggests that over long periods of time, there is no correlation between GDP growth and stock market returns, meaning that UK equity investors shouldn’t be disheartened by the prospect of lower economic growth going forward.
That said, the UK equity market hasn’t been an easy place for investors and fund managers to make money. There has been a significant dispersion of returns between sectors and it hasn’t necessarily been a choice between the defensive or economically sensitive sectors of the market during this economic uncertainty. In the three-year period to 31 July 2012, the FTSE All Share Industrials sector gained 20% per annum while the FTSE All Share Banks sector lost 4.5%. There have been other areas of the market that investors might consider cyclical that have actually performed quite well through the economic turmoil. The media, technology, travel & leisure sectors, albeit fairly small areas of the UK market, have outperformed the traditionally defensive healthcare sector over the same three- year period. There has also been some advantage gained by having exposure to somewhat riskier mid-cap stocks. The FTSE 250 Ex-Investment Trust index has outperformed the FTSE 100 index by almost five percentage points per annum over the past three years.
However, it has been difficult to ignore the severity and celerity of the market volatility and sector rotations along the way. This can be unpalatable for investors but it also highlights the importance of maintaining a long-term view. For example, from the beginning of the year to the end of March 2012, the FTSE All Share Banks sector was up 18% but then in the following four months to 31 July, the index fell 9%. The significant moves in short periods have been driven by investor sentiment which has been fickle in light of uncertainty surrounding the sovereign debt crisis in Europe and weak economic data in the US. Moreover, the developing world was expected to pick up some of the slack left by the slowdown in developed economies but the extent to which emerging economies can lead global growth is increasingly doubtful.
So while the global economic backdrop continues to look extremely challenged, investors with a long term horizon have enjoyed fairly respectable returns from UK equities. Given that almost two-thirds of the revenues from FTSE 100 constituents are derived from overseas markets, most companies don’t rely on a strong UK economy to produce positive returns. Although the international markets are also in a challenging position, the diversity of revenue sources from UK-listed companies can be beneficial to investors.
Below is an outline of a few UK-focused equity funds that have caught the attention of our Morningstar analysts:
Largest Funds
The largest funds list for UK equities is dominated by passive funds, with the iShares FTSE 100 ETF (ISF) at the top of the list with more than $5 billion in assets under management. For investors who are unable to make an informed and in-depth decision in selecting an actively-managed UK equity fund, a passive fund can provide a low-cost way for investors to gain broad exposure to UK equities. It is worth noting that the average fund in the Morningstar UK Large-Cap Blend, Growth and Value categories has underperformed the FTSE All Share index in the three-year period to 31 July 2012, making the case for a passive fund even stronger. However, passive funds are at a structural disadvantage in that no matter how inexpensive the fund might be, a plain vanilla index fund will underperform its index because of fees. Investors should also note the inherent stock-specific risk in a passive FTSE 100 index fund. For example, as at 31 July 2012, the top five index constituents--HSBC (HSBA), Vodafone (VOD), Royal Dutch Shell (RDSB), BP (BP.), and GlaxoSmithKline (GSK)--accounted for almost 30% of the index.
Meanwhile, we believe there is a fairly broad universe of active UK equity fund managers with a proven ability of adding value over the index over the long term. In particular, the Blackrock Global Funds (BGF) United Kingdom fund is rated Bronze by Morningstar OBSR. The fund is managed as a lower-risk UK equity offering relative to the benchmark. James Macpherson, co-head of UK equities, has managed the fund since April 2008 and has over 20 years of experience. We like the depth and scale of the UK equity resource at BlackRock and the strength of the UK team’s stock-picking has shown it can add value. We believe investors seeking a portfolio of core UK names will benefit from this fund's repeatable and well-applied approach.
Best Over Three Years
The Cazenove UK Equity fund is rated Bronze by Morningstar OBSR. The fund has been managed by Julie Dean since she joined Cazenove in December 2002, and she works as a part of the Cazenove Pan European Equity team. The investment process combines both top-down and bottom-up analysis in order to anticipate changes in the business cycle and their impact on share prices. Dean is a pragmatic investor who is willing to trade the portfolio to achieve her objectives. She views the fund as opportunistic and the fund has an all-cap mandate. Indeed, there has been a meaningful exposure to small and mid-cap stocks during her tenure. Thus far the manager has navigated a variety of market environments successfully but investors should be aware that the mandate is all-cap in nature and a narrowly defensive market may prove more problematic.
The Liontrust UK Growth fund is managed by Anthony Cross and Julian Fosh who try to identify companies by two criteria which they believe are the key to successful companies. The first criterion is the strength, sustainability and exploitation of a company's intellectual capital. The second is how key employees are motivated and retained, with the preference being through direct ownership of the company’s equity. Their distinctive investment style has been shown to add value over the long-term and the fund has outperformed in very different market conditions.
Newcomers
The RWC Enhanced Income fund is rated Bronze by Morningstar OBSR analysts and targets a yield of 7% per annum. It offers investors access to a value-oriented UK equity portfolio consisting predominantly of FTSE 350 stocks, which are selected using a bottom-up, research driven investment process. It also uses a call option overlay designed to enhance income. We like the fund because managers, Nick Purves and Ian Lance, have a knack for stock-picking, while manager John Teahan is responsible for the call option overlay. Although the fund is a newcomer, we have familiarity with Nick Purves, Ian Lance and John Teahan from their tenures at Schroder Income and Schroder Income Maximiser.
The Fidelity FAST UK fund is managed by Aruna Karunathilake and the mandate allows him to short unattractive stocks up to a maximum 30% of net asset value. He can also take additional long exposure up to 35% of net asset value. If used appropriately, the ability to take short positions can help manage the fund’s volatility through time.
The Ardevora UK Equity fund is run by the management team at Ardevora which comprises Jeremy Lang, William Pattisson, Ben Fitchew and Gianluca Monaco. Ardevora Asset Management was set up by Jeremy Lang and William Pattison in 2010 and their investment process is grounded in behavioural psychology. In particular they look at the behaviour of analysts, fund managers and company management and attempt to exploit the biases which result from their behaviour.
The original version of this article was published in International Advisor.
