The severe falls in mining and energy stocks over recent months has left UK large-caps positioned for a short-term rally, according to City Financial’s Mark Harris and Charles Stanley Direct’s Rob Morgan, who say a buying opportunity in FTSE trackers may well have opened up. 
A number of FE Trustnet articles have shown how active managers have largely outperformed the UK index so far this year.
Data from FE Analytics shows an equally weighted portfolio of active funds in the IA UK All Companies and UK Equity Income sectors has returned 4.31 per cent so far in 2015, compared to a 0.69 per cent gain in the FTSE All Share. The portfolio of active funds has also had a much lower maximum drawdown than the index.
Those figures do include survivorship bias, but there have been very limited fund closures in 2015 this year.
Performance of active UK funds versus the FTSE All Share in 2015
Source: FE Analytics
The reasons for the underperformance of the index (as shown by the fact that every fund which tracks the FTSE All Share, FTSE 100 and FTSE 350 sits in the third or fourth quartile year to date) have been well documented – namely the huge falls in the energy and mining sectors, which make up a large chunk of the index.
Energy companies (which make up 11.01 per cent of the FTSE All Share) have been hurt by a further fall in oil price, while mining stocks (which account for 5.5 per cent of the index) have also been hit by commodity price falls thanks to China’s slowdown.
All told, UK energy and mining stocks are down 10.94 per cent and 30.94 per cent so far in 2015. This has certainly hindered the index, but given most active managers have avoided those two sectors within their portfolios, it has helped their relative outperformance as a result.
On top of that, the large majority of active managers in the UK have shunned the troubled FTSE 100 index and instead moved to overweight positions in mid and small-caps, which tend to be more domestically orientated and therefore have benefitted from an improving UK economy.
In fact, FE Analytics shows the FTSE 250 and FTSE Small Cap indices have comfortably outperformed the FTSE 100 this year.
Performance of indices in 2015
Source: FE Analytics
This difference in performance has a number of fund managers questioning the best way to now gain exposure to the UK market, however.
One of whom is Mark Harris, head of multi-asset at City Financial, who questions whether mid-caps (which have been an active manager’s best friend this year) will continue to perform as strong given their recent returns and high valuations.
Instead, he is looking to up his exposure to large-cap land.
Currently, he holds Fidelity UK Opportunities, CF Lindsell Train UK Equity, TB Garraway UK Equity, Ardevora UK Income, Royal London UK Equity Income and R&M UK Equity Long Term Recovery for his UK exposure – but those funds don’t give him access to the very lowly valued areas of the FTSE All Share.
When we asked how he is looking to play this theme, he said he is considering going down the passive route for his exposure to play a recovery in some of the FTSE 100’s most bombed-out constituents.
“We’ve just had a debate in the office about this. I haven’t got an answer for you and I’m chewing it over at the moment the best way to go about this such as whether to go for an ETF or an active manager,” Harris said.
The manager points out that investors could turn to active funds which are overweight the energy and mining, but FE data shows they are hard to come by.
Our research shows, for example, that just 23.6 per cent of active funds in the IA UK All Companies sector are overweight mining stocks relative to the index (such as Standard Life Investments UK Equity Unconstrained, Man GLG Undervalued Assets and JOHCM UK Dynamic).
Meanwhile just 10.9 per cent of the peer group’s active funds are overweight energy companies (including M&G Recovery, Liontrust UK Growth and Investec UK Special Situations).
Therefore, and as he wouldn’t be surprised if energy and mining come rallying back over the short term, he thinks using tracker funds may be the best way to go for UK investors.
“What I have been saying about emerging markets applies to mining and energy, the bad news just keeps coming and coming into the price so then they become highly sensitive to marginal improvements in newsflow.”
Performance of indices over 3yrs
Source: FE Analytics
“They’ve fallen about 40 per cent, so they won’t bounce 5 per cent it will be a lot more because everyone is shorting them. All the prop desks are probably short them and all the funds don’t own them, so everyone gets twitchy.”
“The FTSE 100 is almost that type of dynamic so we have been looking whether we should get an ETF with energy and mining because we don’t have any exposure to it – none of our [UK] managers have real exposure to them and they aren’t going to move that quickly so we are going to have to do it.”
FE Alpha Manager John Bennett, director of European equities at Henderson, recently told FE Trustnet that active managers may be in for a nasty surprise over the coming months. His reasoning, like Harris’, is that most active managers have generated their outperformance by avoiding the likes of mining and energy stocks and have therefore been left holding similar stocks.
Therefore, given the huge falls in those two sectors and the proportion they make up of the index, if there were too be any sort of mean reversion most managers would struggle to beat their benchmarks.
“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,” Bennett said.
“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.”
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees with Harris.
While he usually goes down the active route, Morgan says that for those who normally use trackers now is an attractive opportunity to buy broad exposure to the index.
“I am not normally a huge passive fan as I generally think weighting a portfolio by size of company in the index is a bad place to start,” Morgan said.
“However, in terms of relative value right now mega-cap in the UK looks really interesting with 5 to 6 per cent yields on offer. Everyone seems to fear dividend cuts so if these don't transpire there is likely to be an unusually large amount of upside on offer from the UK's largest firms.”
“Miners and energy giants in particular seem to be pricing in a very pessimistic scenario, so yes it’s possibly a good time to buy the index as a shorter term strategy.”
However, given that both mining and energy (along with other UK mega-caps) still face huge challenges, Premier’s Simon Evan-Cook says any rally in those area is likely to be short in nature. Therefore, he says he will maintain active exposure to the UK market within his funds of funds.
“I can understand why [investors] would do that - the main index has had such a trouncing that a bit of a bounceback would be no surprise,” he said.
“But it's not guaranteed either, and timing it correctly relies on luck. So no, we will not be doing that. We have excellent multi-cap active funds that should pick out the large-cap wheat from the chaff.”
Evan-Cook added: “Nobody should underestimate the importance of chaff avoidance, and you don't get that with a tracker.”
