The major reason behind the piece was that, using factsheet impressions on FE Trustnet and the market movements tool on FE Analytics, we could see that funds – which had already demonstrated strong outperformance over a short period of time – were seeing a huge surge in popularity.
While we looked at certain areas of the high yield bond market and took a closer look at investment trusts, the focus of the article was mainly on smaller companies funds and multi-cap income funds within the IA UK Equity Income sector.
To understand why I wrote the article, it’s key to look back at how these funds were performing this time last year.
Thanks to an improving economic backdrop and increased appetite for risk as a result of quantitative easing and ultra-low interest rates, funds with a high weighting to small or mid-caps had enjoyed a very strong run.
According to FE Analytics, during the two years prior to the article being publishing, the average IA UK Smaller Companies fund had returned 54.2 per cent and the average lower-cap UK income fund had gained 66.86 per cent. As a point of comparison, the FTSE All Share was up 24.87 per cent.
Performance of funds and sector versus index between Mar 2012 and Mar 2014
Source: FE Analytics
Given those strong returns, it seemed that many investors wanted a piece of that outperformance in their portfolios before the end of the tax year.
For example, Unicorn UK Income, CF Miton UK Smaller Companies and R&M UK Equity Smaller Companies – along closed Schroder UK Dynamic and Fidelity small-cap funds – were the five funds with the highest number of factsheet impressions on FE Trustnet over the previous month.
On top of that, lower cap income funds such as Unicorn UK Income, Marlborough Multi Cap Income, CF Miton UK Multi-Cap Income and PFS Chelverton UK Equity Income had all seen huge inflows.
Data from FE Analytics shows that the Unicorn fund had grown from £160m to £600m over the preceding 12 months, the Marlborough fund from £273m to £911m, the Miton fund from £56m to £400m and the Chelverton fund £60m to £275m.
While those figures will include the strong performance of those portfolios’ unit prices – the groups were also taking on a lot of money.
Given that smaller company-orientated funds had performed so well and were attracting a lot of money as a result – Chris Mayo, investment director at Wellian Investment Solutions, warned investors were taking a lot of risk and late to the party.
“Private investors often invest on the back of past performance. Just because one area of the market has done well over the past five years, it doesn’t mean it will perform just as well over the next five,” Mayo said.
Chris Spear of Spear Financial agreed.
“Regrettably, it is part of human nature to invest in things that have already done well,” Spear said.
“That is certainly the case with small caps. I read all these articles from people saying that the rally still has legs, but they have had a phenomenal run. Yes, economic conditions are improving, which has tended to benefit smaller companies, but I have a healthy level of scepticism.”
Unfortunately, these comments and the tone of the article were slammed by a number of our readers.
One described the article as “scaremongering” while another, with a phenomenal use of alliteration, said that it was just a “pot-boiling piece of piffle”.
However, since the article was published, the IA UK Smaller Companies sector has lost 1.4 per cent while the average multi-cap fund within the IA UK Equity Income sector has gained half the amount of the FTSE All Share and the sector average.
Performance of funds, sectors and index since 22 March 2014
Source: FE Analytics
Yes, that performance isn’t catastrophic, but investors could have found much better returns if they hadn’t chased past returns. With the benefit of hindsight, we can now understand why that happened.
Whether it was due to the previous stellar gains, increased macroeconomic headwinds or concerns about corporate earnings, there was a fairly severe market rotation out of high-multiple growth stocks into the perceived safety of large cap defensive equities in Spring last year.
Smaller companies were then hit by more market-wide volatility such as the September/October sell-off and the redemptions from notable multi-cap funds in the IA UK All Companies sector also damaged the asset class.
Data from the Investment Association shows, for example, that the IA UK Smaller Companies sector has seen net outflows in each of the last nine months.
Now, I fully understand that this article might come across as self-congratulating, bitter, nonsense and – in some ways – it is.
Clearly, smaller companies offer better long-term growth than their larger and history has proven that over nearly any 10 year time horizon, they have outperformed the wider market. It is also true that timing the market perfectly is almost impossible, which a number of commenters highlighted at the bottom of last year’s article.
Performance of indices over 20yrs
Source: FE Analytics
However, the point of this piece is to illustrate that, for whatever reason, private investors are often late to the party and will chase past returns without fully understanding the risks involved.
“People, unfortunately, look at past performance tables in the expectation that funds which are doing well will continue to do well – which is the complete wrong way of selecting funds,” Rob Morgan, pensions and investment analyst at Charles Stanley Direct, said.
“I did feel that small caps were attracting a lot of attention this time last year and it was becoming a crowded trade within a market that had already had a very strong run.”
Morgan agrees that there is a very slim chance that investors will ever time the market completely right, but he also agrees that they can help themselves out by paying close attention to fund flows, valuations and possible hysteria.
“I think you are absolutely right – you are never going to time the market but you can certainly pick out moments when you shouldn’t be investing,” he said.
“There are always warning signs and one is when there is a huge amounts of attention towards a particularly area of the market. I have always found it is better to back funds which have gone through a period of poor performance rather than ones which have just performed really well. That has always been the one simple rule I have tried to follow.”
However, Morgan stresses that investors shouldn’t compound their mistakes by selling small-cap orientated funds now they have had a poor run and simply crystallise their losses.
While he says there will be inevitable volatility with the upcoming election and the level of the wider market, now is the best time to be looking at smaller companies – especially for investors with long-term time horizons.
A number of experts have agreed that small-caps now look attractive, with the likes of Hargreaves Lansdown’s Mark Dampier saying a buying opportunity has opened up as he labelled them as “unloved, unwanted and unfashionable.”
Looking back through this article, there is certainly a hint of “I told you so” about it. However, the fact of the matter is that we as financial journalists are privy to information and data that private investors simply don’t get access to and if they do, they find out too late.
Therefore, in an article next week and following on from this theme, will we look at various areas of the market that now look like they are nearing their tops and so investors should maybe steer clear of before they finalise their ISA portfolio.