UK investors are being forced to take larger risks than ever as a result of a fiercely competitive and global-facing market, according to research released from JP Morgan today.
The report, entitled ‘a Fresh Take on UK Equities’, has found that UK investors on average hold a 27 per cent weighting in their home region, yet just 25 per cent of the FTSE 100’s revenues are from the UK at all.
The FTSE All Share index is also heavily dominated by blue-chips and has an 80 per cent weighting in FTSE 100 companies, and because of the global nature of these larger companies it has been hit harder by the commodity price collapse.
This has led to the outperformance of small and mid-cap stocks this year, which the report says emphasises the need for investors to be able to increase their exposure to smaller companies when necessary.
Average percentage of revenues sourced from the UK
Source: JP Morgan
“The companies in the FTSE 250 and FTSE Small Cap source a much higher proportion of their revenues from the UK,” the report, which was co-written by chief market strategist Stephanie Flanders, states.
“In comparison, the FTSE 100, due to its global rather than domestic focus, sources less of its revenues from the UK. This degree of market concentration is highly unusual. The top 25 per cent of stocks, ranked by size, account for a much larger share of the UK index than of the other major developed market equity indices.”
According to JP Morgan’s research, 87.8 per cent of the FTSE All Share index consists of stocks in the top quartile for their size, compared to the S&P’s 69.2 per cent weighting and the MSCI Emerging Market’s 67.6 per cent weighting.
The asset management company also found that an equally-weighted FTSE All Share index would have returned significantly more over 15 years, outperforming the FTSE 250, the FTSE 100 and the existing FTSE All Share because of the strong long-term performance of smaller stocks.
Performance of indices over 15yrs
Source: JP Morgan
“This pattern could change in future; investors do not necessarily want to be betting perpetually on UK mid and small-cap companies,” the report continued.
“The point is rather that investors should have the flexibility to dial up and down their exposure to small and mid-cap companies when appropriate. The structure of the UK benchmark indices makes this very difficult to achieve using a narrow, index-based investment approach.”
According to data from FE Analytics, the IA UK Smaller Companies sector has more than doubled the performance of the IA UK All Companies and IA UK Equity Income sectors year-to-date and, because of this, many managers that can invest across the cap spectrum have upped their exposure to small-and mid-caps over recent years.
The lines are arguably becoming blurred now across the sectors because of this.
According to JP Morgan, the performance of the IA UK All Companies over the last three years has been so good because of an increased exposure to small and mid-caps that a UK fund manager has needed to return 5.7 per cent each year to find themselves in the top quartile.
This is a significant level of outperformance compared to other regions such as continental Europe where the top quartile has outperformed by 1.1 per cent, and the US top quartile which has outperformed by just 0.2 per cent.
These excess returns have partially occurred because it has been so easy for active managers in the UK to outperform the struggling FTSE 100 by avoiding large parts of it. What is less clear-cut, according to the report, is why fund managers have found it so much easier recently to build portfolios that can deliver such high outperformance compared to previous years.
JP Morgan believes that the reason for this is that there are simply more top-performing stocks in the UK to choose from now, as the percentage of outperforming stocks has also risen by more than 10 per cent since the start of the millennium.
“This is almost entirely due to the large declines in the value of oil & gas and mining companies, which between them accounted for 29 per cent of the FTSE All-Share in 2011, but now account for just 17 per cent,” the report explained.
“In effect, all that a UK fund manager has needed to do to significantly outperform the benchmark is stay out of these sectors. For example, a manager who zero-weighted the mining sector at the start of 2015 would have garnered a 2.5 per cent outperformance versus the index with just that one decision, in a year in which the sector fell by 40 per cent.”
“The negativity around commodities made this a relative a relatively consensus call and many managers did just that.”
Performance of indices since Jan 2011
Source: FE Analytics
This has of course piled on the competitive pressure for UK investors, and as such JP Morgan warns that more risks are being taken across the board in order for managers to outperform their peers.
According to its research for instance, more than a quarter of actively-managed funds in the IA UK All Companies sector held less than 40 stocks in their portfolio in the third quarter of this year, which the asset management firm says leaves them “excessively exposed” to risks associated with individual stocks.
The report also found that 19 per cent of active funds in the sector hold more than 10 per cent of their weighting in non-UK stocks at the moment, and the average three-year annualised tracking error of UK managers in the first quartile is 5.3, compared to just 3.2 in the US.
JP Morgan warns that such high levels of risk aren’t appropriate for many investors, and that if risk controls have been brushed to one side, any mean reversal in commodity weakness could give managers an unpleasant surprise.
“The past few years in the UK have been unusual, in that the consensus trade has also delivered great outperformance,” the report states.
“When the tide turns on commodities, this era will come to an end and the focus will shift back to traditional drivers of outperformance: research-driven individual stock views, portfolio construction and risk factor management. Some managers will handle the change of direction a lot better than others.”
