Past performance isn’t a guide to the future of course, as an FE Trustnet study recently confirmed. Our research showed that, over the last five years, the large majority of UK equity funds that vastly outperformed one year failed to replicate those relative returns in the next 12 month period.
The results got me thinking; if backing yesterday’s winners gets you nowhere, is there any merit in backing those that have underperformed instead?
Using data from FE Analytics, we put this to the test by analysing the discrete returns of portfolios within the IMA UK All Companies sector.
Over certain timeframes, there does indeed seem to be some method in my madness.
Out of the 67 funds that were bottom quartile in the sector in 2013, 48 of them – 71.6 per cent – are currently outperforming the sector in 2014.
Two of the highest profile names that fit into that category are Liontrust Special Situations and Liontrust UK Growth – both of which are headed-up by the FE Alpha Manager duo of Anthony Cross and Julian Fosh.
Our data shows that £1.2bn Liontrust Special Situations fund, which is renowned for its bias towards quality companies with a strong competitive advantage, returned 19.97 per cent in 2013, underperforming the sector average by more than 5 percentage points.
However, so far this year the fund is up 2.3 per cent, beating the index and the sector average. The latter has lost money so far this year.
Performance of fund vs sector and index in 2014
Source: FE Analytics
A large proportion of the funds which were bottom quartile last year, but have since bounced back, are trackers, including the likes of Vanguard FTSE UK All Share.
Richard Scott (pictured), manager of the PFS Hawksmoor Distribution and Vanbrugh funds, says there is a very obvious reason why the funds which underperformed last year have rebounded in 2014.
“The big thing that has happened over recent years, which has actually changed over the last nine months, is that the average UK fund has outperformed the market,” Scott said. “This has changed quite sharply this year. Year-to-date the majority of small and mid-cap funds are down while the FTSE All Share has remained broadly flat. That is because the top-end of the market has been outperforming.”
It’s not only 2013 and 2014 that have an inverse relationship when it comes to outperforming funds.
In 2011 – a year defined by the eurozone summer sell-off – saw the FTSE deliver a negative return for the first time since the 2008 crisis. 2012, on the other hand, saw markets rebound on the back of quantitative easing and Mario Draghi’s now famous “do whatever it takes” speech.
FE data shows that out of the 64 funds that were bottom quartile in 2011, 41 – or 64 per cent – were first or second quartile in 2012.
More cyclically focused funds such as Standard Life UK Equity Unconstrained, Fidelity Special Situations, Old Mutual UK Mid Cap and FP Matterley Undervalued Assets all considerably underperformed the sector in 2011, but delivered top quartile returns in 2012.
There was a similar change in sentiment between 2010 and 2011.
As mentioned above, returns were hard to come by in 2011 with the FTSE All Share losing 3.46 per cent but in 2010 the index returned close to 15 per cent as the market was still rebounding from the financial crash.
The research shows that close to 80 per cent [49 out of 62] of bottom quartile funds in 2010 went on to beat the sector in 2011.
These include more defensive large-cap portfolios such as Invesco Perpetual High Income, which was managed by Neil Woodford at the time, Alastair Mundy’s Investec UK Special Situations portfolio and JOHCM UK Opportunities, which is headed up by FE Alpha Manager John Wood.
Source: FE Analytics
Prior to that, 70 per cent of funds that were bottom quartile in 2008 came back to outperform the market in 2009.
The results are compelling, but Scott says that it’s dangerous to draw too much from them – particularly as the time frames used are so rigid.
“If you are looking at a particular style that has been out of favour it can be rewarding, but it isn’t a fail-safe thing to do,” Scott said.
“We were engaging with managers last year and we would hope that our active managers will be able to adapt the portfolio towards changing market conditions. While some have been underperforming so far this year, the likes of Thomas Moore and Alex Savvides have been putting money into large-caps.”
Scott says that it’s useful to look at which sectors are out of favour, but believes that the passive vehicles are a much more useful way of taking advantage of valuation opportunities.
“If you are playing the market via ETFs, you could add value by looking at which sectors have over or undershot,” he said.
Indeed, considering underperforming funds for your portfolio has done little to help investors over certain periods, as markets can behave very similarly for two years and even more.
Both 2012 and 2013 saw the FTSE perform very strongly for example; and our data shows that just 30 per cent of the funds that fell into the bottom quartile in 2012 went on to outperform the market the following year.
Obviously, changes in sentiment can occur at any time during the year, as was the case in 2012. It was very much a year of two halves – in the first six months, conditions suited defensive asset classes as macroeconomic headwinds heavily influenced market direction. However, the second half of the year saw risk-assets rally as central-bankers flooded the system with liquidity.
Our data shows that every fund in the IMA UK All Companies sector that was bottom quartile in 2012 failed to outperform the sector in the second half of the year. While not drastically different, 20 per cent of those funds actually outperformed in the first six months of 2012.
2009 and 2010 also saw similar funds perform strongly.
The UK equity market made strong gains in each of those years, and only 18 funds out of a possible 60 UK All Companies funds that were bottom quartile in 2009 managed to outperform in 2010.
While targeting out-of-favour funds at year-end has proven futile in many cases, this isn’t to say that the exercise hasn’t been very effective if used in the right circumstances.
FE Alpha Manager Marcus Brookes and Robin McDonald, who run the Schroder multi-manager range, have rotated between cyclical and defensive funds very effectively in recent years. On a number of occasions that have bought into funds that have struggled on a relative basis, believing that a change in fortune was on the horizon.
As FE Trustnet revealed at the time, the duo chopped down their exposure to defensive managers like Neil Woodford in favour of those with a more cyclical focus like Sanjeev Shah, who are the time was running Fidelity Special Situations.
Shah was coming under increasing pressure following a poor run in 2010, 2011 and the first half of 2012; however, as the graph below shows, Brookes and McDonald’s call paid off.
Performance of funds vs sector Sep 2012 – Feb 2014
Source: FE Analytics
Brookes told FE Trustnet earlier this year that he had sold Fidelity Special Sits as he was concerned that it could be a potential a victim of long-overdue market “shake-up”. Again, his timing was very good indeed; the fund is behind its sector and index since February 2014, with returns of 0.5 per cent.
Simon Evan-Cook (pictured), senior investment manager at Premier, also shifts his portfolios between cyclical and defensive funds. He says he rotates his funds on the basis of valuation – not just because a manager has underperformed.
“It’s really driven on valuation. We will also look to sell if all of a sudden everyone is talking up an asset class after it has already performed well or if press coverage becomes inadvertently positive,” Evan-Cook said. “All sorts of factors come into play, but one thing you will be very unlikely to do is get your timing exactly right. You’ve got to be willing to wait for six months, a year or even longer.”
Both Scott and Evan-Cook agree that sector and manager rotation is very beneficial for a fund manager operating on a relatively short time-horizon, they say everyday investors should be looking over a longer horizon and focus more on “time in” the market rather than “timing” the market.
An FE Trustnet study recently revealed the benefits of long-term investing, highlighting the annualised returns since launch of funds such as M&G Recovery and Schroder US Smaller Companies.
