The outperformance of funds in the IA UK All Companies and IA UK Equity Income sectors over the last five years has been largely dependent on cap size weighting, according to research by SCM.
The report argues that more than 100 percentage points of outperformance of funds in the IA UK All Companies sector over this time frame was down to a small- and mid-cap bias.
Over recent years, the FTSE 100 has lagged indices covering companies further down the market-cap spectrum. While the blue-chip index is up just 33.34 per cent over five years, both the FTSE 250 and the FTSE Small Cap have risen more than 80 per cent.
Performance of indices over 5yrs
Source: FE Analytics
SCM claims that UK funds have been able to beat their FTSE All Share benchmark, which is biased towards large and mega-caps, but simply allocating to smaller companies rather than through genuine active management. It also suggests that similar results could be achieved with trackers.
On average, outperforming funds held in the IA UK All Companies sector 53 per cent in blue-chips, which represent 70 per cent of the UK stock market, and 47 per cent in small- and mid-caps, which represent 30 per cent of the UK stock market combined.
The group also claims the performance of the IA UK All Companies sector almost mirrors an investment of 55 per cent in a FTSE 100 tracker and a 45 per cent in a FTSE 250 tracker over the five years to the end of June this year.
“Our research is yet another nail in the coffin of the majority of active funds,” Gina Miller, co-founder of SCM Direct, said.
“Simply buying a combination of a FTSE 100 tracker with a FTSE 250 tracker, closely resembles the performance of a typical actively managed UK equities fund, while saving over 80 per cent of the annual cost (based on a typical tracker charging circa 0.15 per cent ongoing charge versus a typical UK active fund charging circa 0.85 per cent ongoing charge).”
“Following the outperformance of small- and mid-cap stocks, many of these stocks now command a premium valuation compared to their larger peers. This may negatively impact the future returns of many active funds in these two major sectors.”
SCM Direct studied 179 active UK equity funds with combined assets of £122bn, all of which had a five-year track record from June 2010 to June 2015, had monthly market cap data available and aimed to beat the FTSE All Share index.
The research shows that in the IA UK All Companies sector the average percentage of large-caps held has decreased by 1.8 percentage points and the percentage of mid-caps has increased by 2.4 percentage points over five years.
The number of small-caps has decreased by 0.7 percentage points but, on an annual basis, the average percentage of small-caps in the funds over five years is still almost double the 10 per cent weighting of the UK index at 18.9 per cent.
Sector exposure by size of UK stocks held
Source: SCM Direct
The IA UK Equity Income sector followed a similar pattern in terms of a drop in large-cap weightings, an increase in mid-cap weightings and a small decrease in small-cap weightings. Again, large-caps are significantly underweight the index while mid- and small-caps are overweight the index.
“When you strip out the effects of this inherent bias to small and medium-sized companies, the outperformance for UK All Companies funds disappears and nearly disappears for UK income funds,” the SCM report said.
“If an investor had invested via a simple combination of a FTSE 100 tracker with a FTSE 250 tracker [SCM used the HSBC FTSE 100 and FTSE 250 index funds within this analysis], the results were astonishingly similar to the so called ‘actively managed’ IA UK All Companies sector funds, again demonstrating that performance is largely dependent on the size bias of each fund.”
Out of the 179 sample selection, only four funds managed to beat the market cap-adjusted returns of their fund in each of the 12-month periods to the end of June 2015. 
These were FE Alpha Manager Nick Train’s (pictured) Lindsell Train UK Equity, James Lowen’s JOHCM UK Equity Income, Alan Clifford’s Lazard Multi-Cap UK Income and Martin Cholwill’s Royal London UK Equity Income funds.
On the opposite end of the spectrum, the funds that consistently underperformed the returns of their market cap-weighted investments every year over five years were Rodger McNair’s F&C UK Equity Income, Tom Dobell’s M&G Recovery, Bob Brown’s MFM UK Primary Opportunities and Scottish Widows UK Select Growth.
Market cap-adjusted annualised outperformance/underperformance of funds over 5yrs
Source: SCM Direct
In a coming article, FE Trustnet will ask the experts for UK fund managers that have proven themselves able to successfully invest in large-caps without relying on smaller companies.