Indices are likely to rally over the coming few months as bombed-out sectors such as oil, mining and utilities show signs of short-term mean reversion, according to FE Alpha Manager John Bennett, who warns that given most managers are avoiding those areas and are therefore all are holding similar stocks, active funds are likely to underperform over the remainder of 2015. 
There is little doubt that it has been a poor time to be invested in passively managed funds as indices have been ravaged by a variety of macroeconomic headwinds such as potentially higher interest rates, China’s slowdown and falling commodity prices.
However, as those concerns have only hurt certain areas of the equity market (mainly mining, oil & gas and utilities) active managers have been able to avoid those sectors and shelter their investors’ cash elsewhere.
According to FE Analytics, apart from the North America and Global Emerging Markets, all of the major equity peer groups in the Investment Association universe are outperforming their respective indices in 2015. In the UK, for example, the IA UK All Companies sector average has beaten the FTSE All Share by 2.5 percentage points this year.
Performance of sector versus index in 2015
Source: FE Analytics
However Bennett, who heads up a variety of European equity portfolios at Henderson including the group’s £2bn European Selected Opportunities fund, says trend is about to change given that largest constituents of the index have seen the biggest losers during the recent market rout.
“I believe the index is set to make a bit of a comeback. It might only last a month or three months, but it could be a painful one against active managers,” Bennett (pictured) said.
He admits it is a very contrarian way of thinking, especially given he is an active manager. However, his concerns were raised as his funds have been well ahead of their respective benchmarks over the past 12 months but have failed to shine relative to other active funds.
“This is really quite interesting and, right now as we speak, so contrarian that you’d be marched right out of the room because you’re seen as mad to even consider it,” Bennett said.
“This really strikes me and it’s worth investors dwelling upon because I think it tells a lesson. If you look at the one-year performance of our fund, I have rarely seen anything like this. That is when a fund is 510 basis points ahead (net of fees) ahead of an index and still is second quartile.”
“Usually that’s enough to make you at least first quartile if not top decile. What that is telling me is an index, especially a pan European index, is having a miserable time and has been easy to beat. Why, well you’ve only had to avoid utilities, avoid oil and avoid mining.”
All three sectors, as Bennett points out, have had a torrid few months.
Oil stocks have struggled due to the huge fall in the price of Brent crude, mining stocks have fallen as China’s slowdown has put pressure on commodity prices such as iron ore and utilities struggled earlier in the year as bond yields spiked – though they have come rallying back over recent months.
Performance of indices in 2015
Source: FE Analytics
“Together [utilities, oil and mining], they are quite a big slug of the index and I would imagine the great majority of European managers have done exactly that – including ourselves.”
In his most recent webcall, Bennett was focusing on his Henderson Gartmore Pan European fund, which is benchmarked against the MSCI Europe index, which includes the UK equity market.
Within the MSCI Europe index, oil & gas, mining and utilities make up a combined 17.62 per cent. However, if those three sectors were to see a rebound, it would be worst felt among the UK’s active management community.
The major reason for that is because they make up more than 20 per cent of the FTSE All Share – oil & gas (11.01 per cent), mining (5.5 per cent) and utilities (3.69 per cent) – and, as Bennett points out, most active managers are underweight those areas.
In fact, data from FE Analytics shows that each of the 34 passively managed funds in the peer group which track the FTSE 100, FTSE 350 or the FTSE All Share are either currently sitting in the third or fourth quartile so far this year.
Bennett says that despite the surge in popularity surrounding funds’ active share and increasing belief that a high active share is important, looking more like the index may be the best way to outperform over the coming months.
“We get asked that a lot – what is your active share? It was mentioned to me last week that my active share was low at 70 per cent. At a time when it’s been easy to beat an index by disowning large parts of it, that really strikes me that the index is getting ready to make a comeback against active managers.”
“It will, in my view, be a short-term mean reversion. However, we are shaping up for the big ugly ducklings of oil and resources to make a sharp recovery. It would be a nice sting in the tail for Q4 year end for most active managers if those areas have a V-shaped mean reversion to the upside and come and take all that alpha away.”
“In other words, that’s what indices do and I think we need to be at least mentally prepared for the fact that perhaps too many active managers are camped in the same places: growth stocks and mid-caps.”
Data from FE Analytics suggests that active funds within the IA UK All Companies sector would be at risk if oil & gas, mining and utilities were to witness a snap rally over the coming months.
Our data shows, for example, that just 23.6 per cent of active funds in the sector are overweight mining companies. The ones that are include Standard Life Investments UK Equity Unconstrained, Man GLG Undervalued Assets and JOHCM UK Dynamic.
Schroder Recovery, JOHCM UK Opportunities and Mark Barnett’s various Invesco Perpetual income funds are among the select 13.4 per cent of IA UK All Companies funds which are overweight utilities while just 10.9 per cent of the peer group’s active funds are overweight oil & gas companies.
That 10.9 per cent includes M&G Recovery, Liontrust UK Growth and Investec UK Special Situations.
Bennett has a long and successful track record of outperformance, having beaten his peer group composite in 11 of the last 15 calendar years.
One of his best relative performers, certainly over recent years, has been his £453m Henderson European Focus fund which he took charge of in February 2010 following the group’s acquisition of Gartmore.
According to FE Analytics, it has been a top decile performer in the IA Europe ex UK sector over that time with returns of 82.26, more than doubling the returns of its FTSE Europe ex UK benchmark in the process.
Performance of fund versus sector and index under Bennett
Source: FE Analytics
The fund has beaten both the sector and index in every full calendar year since Bennett took charge and has been top decile for its maximum drawdown, risk adjusted returns (as measured by its Sharpe ratio) and annualised volatility since he has been at the helm.
Henderson European Focus is currently overweight healthcare, but underweight the likes of utilities, mining and oil & gas like many of its peers.
