Investors should largely avoid the UK market in 2016, according to Apollo’s Ryan Hughes, who says the headline index is in for a tough period due to its make-up and the inevitable uncertainty over the EU referendum. 
2015 turned out to be a very odd year for UK equity investors as while the FTSE All Share made a small gain and the large-cap FTSE 100 index fell in value, certain actively managed funds in Investment Association’s equity peer groups delivered strong double-digit gains.
The reason for this trend is relatively simple.
The FTSE All Share is some 80 per cent weighted to the FTSE 100, which itself has high exposure to commodity-related companies (such as mining and oil) that were panned for most of the year. On top of that, other parts of the FTSE 100 are highly exposed to international trade which was hit by China’s slowdown.
Performance of indices in 2015
Source: FE Analytics
On the other hand, mid and small-caps enjoyed a decent year with gains of close to 10 per cent as they were out of favour heading into 2015 and they benefitted, due to their more domestic bias, from an improving UK economy and the surprise Conservative victory during the general election.
Therefore, by avoiding large parts of the FTSE 100 and instead taking reasonable bets in the FTSE 250 and FTSE Small Cap indices, the majority of active managers were able to outperform the wider market with relative ease.
According to FE Analytics, for example, 75 per cent of active funds in the IA UK All Companies sector beat the FTSE All Share last year while 37 out of the peer group’s tracker funds ended 2015 in the third and fourth quartile – the exceptions being two mid-cap trackers and a passive offering with an ethical screen.
Some argue that, given how far some of the largest constituents of the index have fallen and as so many active managers are underweight the FTSE 100, 2016 could prove to be a good year for passive funds relative to active portfolios due to mean reversion.
Hughes, who is the lead manager of the £31m FP Apollo Multi Asset Balanced fund, disagrees entirely.
“We have made no secret of our dislike of UK equities through 2015, a view which proved to be correct given that the FTSE 100 index has fallen by 1.3 per cent,” Hughes (pictured) said. “Looking forwards, it is hard to see this changing in the short-term given the structure of the index.”
The manager’s major concerns surround the index’s significant weighting to commodity-related companies, especially given the China-led global slowdown in trade.
“With such a significant weight to oil and mining stocks at nearly 15 per cent the UK market is highly correlated to the performance of these equities and in turn the performance of the Chinese economy given it is the largest consumer of resources,” he said.
“With the oil price having collapsed in 2015 due to a significant oversupply, there seems little short-term respite for the FTSE.”
Performance of index in 2015
Source: FE Analytics
Certainly, the FTSE 100 index has already been rocked significantly by heavy selling in China as a result of recent poor PMIs, the devaluation of its currency and worries about a ‘hard landing’ in its economy.
At the time of writing, the index is trading at 5,917 which constitutes a 6 per cent fall (in price terms) since the start of the week.
However, Hughes says it is not just China that will hurt the index this year.
“In addition, 2016 is likely to bring the added complexity of the referendum on Britain’s membership of the EU. This is highly likely to create headwinds for the UK market and sterling as the picture becomes clearer,” he said.
While no date has been arranged, many expect the UK to go the polls over its relationship with the EU at some stage this year. Several leading industry experts, such as FE Alpha Managers Mark Barnett of Invesco Perpetual and Mark Martin from Neptune, view the ‘in-out’ referendum as one of the major headwinds facing investors this year.
“With the general election now behind us, the major cloud on the political horizon relates to the UK’s in-out referendum on membership of the European Union,” Martin said.
“The prospect of Brexit does not appear to have weighed on sentiment so far, though there currently remain more questions than answers. In particular, there is as yet minimal insight into negotiations on the terms of UK membership, or indeed the timing of the referendum, which is currently slated for 2017 but could happen earlier.”
“As we gain more clarity on these issues we may see increased market volatility; whilst Brexit is a very real possibility, it is not our central expectation.”
While Hughes is nervous about the UK index, that doesn’t mean he is avoiding the region altogether within his portfolio.
“We continue to see long-term value in the mid and small-cap space away from the FTSE 100,” he said.
Hughes, who narrowly outperformed his peer group composite in 2015’s volatile conditions but is underperforming over longer time frames, holds one designated mid and small-cap UK fund within FP Apollo Multi Asset Balanced – Montanaro UK Income.
The five crown-rated fund, which is £123m in size, was launched Charles Montanaro in December 2006.
According to FE data, it has been one of the IA UK Equity Income sector’s best performers over that time with gains of 132.24 per cent, beating the peer group average by some 85 percentage points in the process.
Performance of fund versus sector since launch
Source: FE Analytics
It must be noted, however, that for the large part of that time the fund was a pan-European smaller companies portfolio and only moved into the UK equity income sector in early 2014.
The fund, which is domiciled in Ireland, has 84 per cent in the UK market and some 71 per cent of the portfolio is invested in companies with a market cap of less than £2.5bn. Montanaro’s largest sector weightings include financials, industrials and consumer services.
Montanaro UK Income yields 3.5 per cent and has an ongoing charges figure of 0.34 per cent.
