Investors concerned by the potential for anti-business policies from a Labour-led government should consider looking at mid-cap funds, according to FE Alpha Manager Mark Martin, who argues that these portfolios are likely to be less exposed to threatened sectors. 
Until recently, the consensus appeared to be that the general election would ultimately lead to ‘more of the same’, with a hung parliament paving the way for a dominant Conservative Party to form another coalition government with the Liberal Democrats.
However, the likelihood of a Labour-led government, possibly with the Scottish National Party (SNP), appears to be growing. Data from electionforecast.co.uk puts Labour on 270 seats and the SNP on 48, higher than the coalition with the Tories tipped for 279 seats and the Lib Dems just 27.
A poll by stock broker IG found that Miliband has overtaken David Cameron as the likely next prime minister among its clients. IG’s clients say there is a 60 per cent chance that Miliband will lead the next government; in mid-March they gave it just a 34 per cent chance.
The poll still tips the Tories to win more seats than Labour, but reiterated the remarkably high uncertainty surrounding the looming election.
Matt Brief, head of dealing at IG Group, said: “Over the last 10 days IG clients have become increasingly convinced that the Conservatives will win the most seats in parliament, but Ed Miliband will be the UK's prime minister.”
“The two most likely scenarios emerging are a Labour minority government informally 'supported' by the SNP or another Conservative and Liberal Democrat coalition. While our clients are convinced there will be a late swing towards the Tories, the longer the polls stay deadlocked the more unlikely it becomes that a late shift in support for Cameron will be enough to keep him in 10 Downing Street.”
Given this backdrop, investors could be forgiven for concern. While a Conservative-Liberal Democrat coalition would be seen as the more market-friendly outcome, a Labour-led government would put a shadow over a number of industries seen as stalwarts for funds focused on large-caps.
Martin (pictured), who manages the five FE Crown-rated Neptune UK Mid Cap fund and took over the Neptune UK Opportunities fund in February, says the election is something he and co-manager Holly Cassell spend a lot of time thinking about – especially given how far markets have come.
Performance of indices over 3yrs
Source: FE Analytics
“I’m a little bit worried about the short term in the market because valuations are fairly elevated – although not as high as they were in 2000 – and we know there’s a lot of uncertainty around the general election,” he said.
“Even if we were to miraculously get some political stability, ie the same Tory-led majority government, that would seemingly be good for equity market but then we’d know we’d be facing an EU referendum. There’s a lot of uncertainty around and markets are highly valued, so at a market level I’m cautious but I’m still finding lots of opportunities in individual companies.”
The manager adds that the prospect of an in-out referendum on the UK’s membership of the European Union is by far the biggest threat of another Conservative-led government. This would create another 18 months of uncertainty for the UK, which would affect most parts of the market and offer fund managers few places to hide in.
Aside from that, the policies mooted by the Conservatives have created few sector-specific risks that a portfolio needs to be prepared for.
Cassell said: “There’s a couple of things that are affecting our portfolio. First of all there’s the general uncertainty surrounding the election outcome and a possible EU referendum, all the rest of it. We’re tending to play that through weak sterling/strong dollar-type companies – so industrial exporters, healthcare companies and the like.”
When it comes to Labour the picture is very different. Martin said: “Labour doesn’t seem to be too keen on big business and in both funds we’re overweight mid and small-caps. If you look at where the obvious political footballs are, they are broadly speaking in large-cap companies like utilities and banks.”
Cassell says there are a few “high-risk” sectors that it could be wise to avoid at the moment based on likely direction of a Miliband government, especially if this comes with the SNP in a supporting role.
“If you look at the Labour party manifesto they’re talking about a levy on tobacco companies and you have energy price freezes that have been bandied around for a while. There’s other sectors you might be more worried about, from things like bank levies and Miliband talking about Lloyds and RBS having too large a market share,” she said.
“Defence is another. Labour and the Tories are both committed to Trident but Labour are talking about potentially having three Trident submarines as opposed to the current four. That would have an obvious impact on companies like BAE, Rolls Royce and Babcock, potentially.”
Neptune UK Mid Cap and Neptune UK Opportunities, which is an all-cap fund but has a bias to mid and small-caps, have minimal exposure to the parts of the market deemed to be most at risk from a Labour election victory.
This not necessarily the case for all UK funds, especially as sectors such as financials make up a significant part of the benchmark while areas like tobacco and utilities are important hunting grounds for mangers of equity income portfolios.
Martin said: “It’s definitely a risk in the market and I’m not saying it won’t impact the fund, but I think on a relative basis we’re well positioned.”
Performance of fund vs sector and index since launch
Source: FE Analytics
As the graph above shows, Neptune UK Mid Cap has significantly outperformed its FTSE 250 benchmark and the average fund in IA UK All Companies sector since launch in December 2008, with a total return of 313.27 per cent. It also has a good track record of protecting capital in difficult markets.
The fund takes a ‘silo’ approach to minimise risk, splitting the portfolio into three types of stock: recovery, or companies that should do well if economic conditions improve; structural growth, or sectors such as healthcare that are growing despite a sluggish overall economy; and self-help stories, which are struggling companies that have the potential to turn around.
It was the only mid-cap fund to appear on the FE Research Select 100, but is currently on hold as FE’s analysts believe there are “better opportunities” outside of the mid-cap space.
However, they said of the fund: “Martin clearly has skill in identifying valuation opportunities in the mid and small-cap area. This, along with the silo approach, is the key to the stability of the fund and offers a lower-risk method of accessing a traditionally high-risk part of the UK market.”
Other mid-cap funds have been highlighted by Square Mile Investment Consulting & Research: both Old Mutual UK Mid Cap and Franklin UK Mid Cap have been given an A rating.
Old Mutual UK Mid Cap is headed up by FE Alpha Manager Richard Watts and has beaten its FTSE 250 benchmark in eight of the past 10 full calendar years. However, since Watts took over at the end of 2008, it has returned around 20 percentage points less than the index with a 263.79 per cent total return.
Square Mile said: “The team have consistently applied their ‘market cycle’ approach to investing over a number of years which has generally proven to be successful over the life of the product. The most notable exception was in the first half of 2009 when the team underestimated the strength of the recovery in the UK (and global markets) and hence the fund underperformed by a considerable margin during that period.”
Meanwhile, Franklin UK Mid Cap is helmed by FE Alpha Manager Paul Spencer. It has been the third best performing fund in the IA UK All Companies sector since Spencer joined the portfolio in February 2006, producing a total return of 240.10 per cent.
“In running this fund (and its precursor), Mr Spencer has built a long and successful track record with the fund proving very resilient during difficult market conditions,” Square Mile’s analysts said.
“This is a solid proposition for investors looking for a pure FTSE 250 play run by an experienced and pragmatic investor, while the fund's emphasis on capital protection should mean a less bumpy ride during volatile market conditions.”
