Investors should now be turning to mid and small-cap orientated funds for their UK exposure, according to various industry experts, with many warning over the immediate outlook for large-cap and income-focused portfolios in the current environment.
Though the FTSE 100 broke through its historic high in the early part of the year, 2015 had all the makings of a turbulent one for UK investors with the general election on the horizon and all the political uncertainty that was associated with it.
Performance of indices in 2015
Source: FE Analytics
However, the surprise Conservative majority gave the market greater confidence which saw sterling strengthen and meant the equity market has surged. Indeed, a recent FE Trustnet poll highlighted that 57 per cent of the 2,187 of our readers who voted said the election result meant they were more likely to buy UK equities. 
Nevertheless, a number of leading industry experts say investors need to be selective when it comes to choosing their UK fund given the high valuations at an index level and other risks allied with the current macroeconomic environment.
One of whom is Mark Harris, head of multi-asset at City Financial, who recently told FE Trustnet that that he expected a “brutal” period in the bond market later in the year as US growth starts to strengthen and the US Federal Reserve begins to push up interest rates.
As a result, the manager has been selling down his exposure to UK equity income funds and portfolios with high exposure to more defensive areas of the market as though they have been some of the prime beneficiaries of ultra-low interest rates, he thinks they are due a period of underperformance as bond yields start to rise.
“We looked at the returns from our income funds and, in particular, one which had outperformed for five years and was outperforming this year by 5 per cent relative to its benchmark. We just thought the probability of this continuing is very, very low so we have reduced and we have reduced across the board,” Harris said.
“The simple reason is if bond yields go up they offer more competition for investors’ attention against equity income styles because suddenly your bond yield rises to 3 per cent against an equity income yield of, say, 3.5 per cent.”
“Look, these funds have been outperforming for such a long period of time, they have become very consensual trades and I can’t find anybody who doesn’t like them so we thought why don’t we trim up here?”
He added: “To put it very simply, you want to buy low and sell high.”
Bond yields have risen substantially over recent months and, as a result, the likes of Margetts’ Toby Ricketts have voiced concerns similar to Harris’.
Ricketts has therefore been selling FE Alpha Manager Terry Smith’s £3.5bn Fundsmith Equity fund because of its high exposure to defensive mega-cap dividend paying equities and warns that the likes of CF Woodford Equity Income and CF Lindsell Train UK Equity could also be in for a difficult time due to their weighting to “bond-proxy” stocks.
While investors may be happy to sit through a period of underperformance from their core UK income fund in search of longer-term outperformance and a healthy dividend stream, Harris says it is time to look elsewhere for opportunities.
“We have now rotated into mid and small-cap managers and in particular we have bought R&M UK Equity Long Term Recovery and we have substantially added to Leigh Himsworth’s Fidelity UK Opportunities fund, which has underperformed recently.”
Hugh Sergeant’s £128m R&M UK Equity Long Term Recovery fund focuses on bombed-out companies that the manager thinks are due a rebound. It has just 34 per cent in the FTSE 100 and more than 40 per cent split across the FTSE 250, FTSE Small Cap and FTSE AIM indices.
FE data shows it has been a top quartile performer in the IA UK All Companies sector since its launch in July 2008 with returns of 143.43 per cent, meaning it has beaten the FTSE All Share by more than 60 percentage points in the process.
Performance of fund versus sector and index Jul 2008
Source: FE Analytics
The fund’s strategy and approach means it has underperformed over the past 12 months, however.
That is a similar story with FE Alpha Manager ‘hall of famer’ Leigh Himsworth’s £63m Fidelity UK Opportunities fund.
Himsworth has more than doubled the gains of his peer group composite during his long career in fund management (he has previously worked at Royal London, Gartmore and CF Eden) and his current fund has beaten both the sector and index since its launch in September 2011.
Performance of fund versus sector and index since Sep 2011
Source: FE Analytics
However the fund – which has more than 70 per cent of its invested assets outside of the FTSE 100 – was bottom quartile in 2014 with losses of 3 per cent due to his highly-active, benchmark agnostic and value approach.
Harris added: “It’s very simple, sometimes you need to plug-in a bit of common sense and say actually that style has massively underperformed [but] that manager is a good manager, so why don’t I buy his fund?”
Nick Roberts, who co-manages the JPM Fusion fund of funds range with Tony Lanning, agrees that investors should be avoiding FTSE 100 stocks in the current environment.
“We’ve been fairly underweight UK equities for a while now and that is because, at the large-cap end, it doesn’t look very appealing,” Roberts said.
“Sterling has strengthened on the back of the election which is a headwind for many mega-caps and we don’t know if that will continue or not as the chance of a ‘Brexit’ is on the cards. However, if you look at the FTSE 100 it is largely made up of mining stocks, energy stocks, consumer staples and pharmaceutical companies.”
“Commodities clearly have issues at the moment and some of the staples are now too expensive and bond proxy-like. On top of that, their growth outlook isn’t particularly attractive either. Therefore we wouldn’t advocate using a FTSE 100 tracker.”
Roberts currently uses Blackrock UK Focus due to its bias towards mid-caps and Liontrust Macro Equity Income for FE Alpha Managers Stephen Bailey and Jan Luthman’s thematic process. He has also been buying the four crown-rated Aberforth UK Small Companies fund which was launched by Alistair Whyte and Richard Newbery in March 1991.
“We like the Aberforth fund as sterling strength shouldn’t be an issue. The managers have a strict value-bias and small-cap valuations aren’t expensive. If we were to add to our UK exposure, we would go for small-caps.”
According to FE Analytics, it has been one of the best performing IA UK Smaller Companies funds over the past 20 years. Its returns of 1,184.69 per cent over that time are nearly 500 percentage points more than those of its Numis Smaller Companies ex IT benchmark.
Performance of fund versus sector and index over 20yrs
Source: FE Analytics
Owing to its focus on value rather than growth, Aberforth UK Small Companies has struggled on a 10-year view but it is outperforming over one, three and five years.
Adrian Lowcock, head of investing at AXA Wealth, also thinks that now is the time to be looking at UK smaller companies.
He points out that the sector has been hit by redemptions (close to £1bn has flown out over the past 11 months) and valuations are attractive with the FTSE Smaller Cap ex IT’s P/E ratio is nearly half that of the FTSE 100. Meanwhile, there are signs of a pick-up in the UK economy as business confidence is growing in the services sector and households are benefiting from the lower oil price.
“With stock markets hitting new or multi-year highs, finding investment opportunities at cheap valuations has become more difficult. Whilst the UK market is not cheap, smaller companies are one of the more attractive areas where relative value exists” Lowcock said.
“Investing in smaller companies requires more than just buying at low P/E multiples. Talented managers are able to identify companies which are growing rapidly and have strong earnings growth which may justify a much higher valuation.”
One of his favourites within the sector within in the sector is FE Alpha Manager ‘hall of famer’ Daniel Nickols’ Old Mutual UK Smaller Companies fund.
He also likes the lesser-known and nimbler £160m Franklin UK Smaller Companies fund, which has witnessed a huge change in fortunes since Richard Bullas and Paul Spencer took charge in June 2012 following a prolonged period of underperformance under previous manager Stuart Sharpe.
Performance of fund versus sector index since June 2012
Source: FE Analytics
“Bullas and Spencer are pragmatic managers with a three-pronged approach: the backbone of the fund is composed of high quality, steady growth companies. These are complemented by under-appreciated and undervalued companies,” Lowcock explained.
He added: “The final prong is recovery stories which tend to be more cyclical in nature.”