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Five reasons why you’re wrong to write off UK growth funds

05 May 2015

IA UK All Companies and UK Smaller Companies have been out of favour for some time, but investors fleeing the sectors are missing out on a range of excellent opportunities. Here are five of them.

By Joshua Ausden,

Head of FE Trustnet Content

Over 70 per cent of the UK’s leading fund selectors believe that the out-of-favour UK All Companies sector is due a comeback, according to an FE Trustnet survey, with many also expecting better things from underperforming UK Smaller Companies funds.

Recent stats from the Investment Association (IA) revealed that the £980m monthly outflow from UK All Companies funds in March was the biggest on record, beating the £854m figure in September 2014. Money has been pulled out of the sector in 10 of the last 11 months.

The picture has been just as bleak for UK small cap funds, which have suffered 11 months of consecutive outflows totalling over £1bn. This means assets in the sector have shrunk by almost a tenth over the period.

Whereas UK growth has struggled, UK Equity Income has gone from strength to strength, gathering inflows every month for over a year. CF Woodford Equity Income has been the biggest beneficiary, though products from Threadneedle, Royal London and Troy have also taken hundreds of millions of pounds.

Are UK All Companies funds due a revival?

 

Source: FE Trustnet

The vast majority of the 45 investment professionals we surveyed, which includes the likes of F&C’s Scott Spencer, Saunderson House’s Ben Williams and Rowan Dartington’s Tim Cockerill, have major holdings in UK Equity Income, but seven out of 10 believe the run away from UK growth has gone too far.

Small caps are being backed particularly strongly; when asked what part of the UK market they were most optimistic about over a three year period, 55 per cent said small cap, 24 per cent said large caps and 21 per cent went for mid-caps.

Around two thirds of the delegates said they had either increased or were thinking of increasing their allocation to small and mid-caps in light of the poor period of performance since February last year. Hargreaves Lansdown's Mark Dampier expressed interest in small caps in particular in a recent interview with FE Trustnet

Has the weak period of underperformance for UK small and mid-cap funds made you more likely to buy them?

 

Source: FE Trustnet

Ultra low interest rates have been one of the biggest drivers in the popularity of UK Equity Income, with the hunt for yield undoubtedly propping up prices. FE data shows that the average UK Equity Income fund has beaten its UK All Companies rival over one, three and five year periods. It is even further ahead than the FTSE All Share over all of these periods.

Performance of sectors and index over 5yrs

 

Source: FE Analytics

Whether this strong performance for yielding companies can continue is up for debate among industry professionals. Ruffer’s Steve Russell recently told FE Trustnet that many areas of the UK Equity Income market are in bubble territory and are susceptible to a correction, and even manager of the Trojan Income fund Francis Brooke admitted rising interest rates will result in a testing time for the sector.


The minds of retail investors seem to be made up, however. Among the biggest losers of the slight from UK growth include M&G Recovery, AXA Framlington UK Select Opps, BlackRock UK Special Sits and Schroder UK Dynamic Smaller Companies, which have all had varying degrees of disappointing performance over the past three years. Schroder UK Opportunities has been hit by not only poor returns but the high profile exit of manager Julie Dean.

It should be noted that the £4bn worth of outflows from Invesco Perpetual Income and High Income over the last 12 months have been a big contributor to the overall figure. Both funds, which continue to suffer outflows in light of Neil Woodford’s exit, were moved from IA UK Equity Income into IA UK All Companies last year due to their inability to hit the 110 per cent yield target, but are in essence UK equity income portfolios.  

Gavin Haynes, managing director of Whitechurch Securiteis, is relaxed about the prospect of rising interest rates, and therefore continues to back UK Equity Income across client portfolios. That said, he believes it remains important for investors to have exposure to both asset classes, as there are significant opportunities across the UK All Companies and UK Smaller Companies sectors.

“As a result of lack of inflationary pressure, an increase in UK interest rates in 2015 seems unlikely and we expect that income producing shares will continue to be sought after,” he said.

“With the impending general election and the UK stock market hitting new peaks, it is not a surprise to see some profit taking from UK growth funds. However, we still believe that there are good opportunities for UK stock-pickers in the sector.”

“If the election should provide a favourable outcome for investors then this would attract monies back to UK growth funds.”

Haynes points out that there are a huge range of different styles across the two UK growth sectors, which allow investors to build a portfolio of funds facing in many different directions.

There are, for example, a stable of UK growth manager that look to add value predominantly by investing in large caps. The FTSE 100 is very popular with income managers, but funds in the UK All Companies sector aren’t constrained by the yield target, and won’t necessarily be as affected by a rising interest rate environment.

Two examples include Nick Train’s CF Lindsell Train UK Equity fund and Richard Buxton’s Old Mutual UK Alpha fund.

Train is an ultra high-conviction stock picker, who has a preference for quality large cap companies with strong brands and pricing power. Many of his favourite companies have significant international exposure, such as Unilever, Diageo and Heineken.

His 25-30 stock portfolio is a top decile performer over one, three, five and 10 year periods, and has beaten its sector average every calendar year since inception

Performance of fund, sector and index over 5yrs

 

Source: FE Analytics

The £1.5bn fund also has the advantage of being cheap, boasting an ongoing charges figure of just 0.77 per cent.

Buxton is also a high conviction manager with a low turnover, but is perhaps more sensitive to valuations than Train. He believes there are big opportunities in financials and retail banks in particular, including HSBC, Barclays, Lloyds, Friends Life and St James’ Place in his top-10.

He tends to perform much better in up market than down markets, but over the long-term has added significantly value to his FTSE All Share benchmark. Buxton was a top quartile performer with the Schroder UK Alpha Plus fund between 2002 and 2013, and his Old Mutual UK Alpha portfolio has achieved the same feat since he started running it in 2010.

Buxton is certainly valuation aware, but some managers take it a step further and invest only in cheap, out-of-favour companies. Some UK income funds have a deep value style – most notably Schroder Income and GLG UK Income – but they are few and far between.

One fund that is drumming up a lot of interest among selectors is CF Miton UK Value Opportunities portfolio. George Godber and Georgina Hamilton focus on unloved companies whose value has not yet been appreciated by the market. They are prepared to invest in small, mid and large caps.


The managers put a huge degree of emphasis on company finances, which they say allows them to unearth hidden gems across the market. Godber says he focuses more on hard assets and cash flow rather than profits, as these can be easily manipulated and are often overstated.

Performance has been stellar since launch; FE data shows the fund has returned 42.17 per cent, putting it almost 20 percentage points ahead of the sector average.

Performance of fund, sector and index since launch

 

Source: FE Analytics

When it comes to dedicated small and mid-cap funds, investors are spoilt for choice. While there are a growing number of UK Equity Income funds specialising in companies outside of the FTSE 250, ignoring those in IA UK All Companies and UK Smaller Companies cuts down your options by well over 90 per cent.

Two funds that score very highly across FE's suite of ratings are Neptune UK Mid Cap and R&M UK Equity Smaller Companies, which both have five FE Crowns and are headed up by an FE Alpha Manager. 

Performance of funds, sectors and benchmarks over 1yr



Source: FE Analytics

Both funds have very strong records, and reassuringly have protected better against the downside than their peers and benchmarks over a turbulent 12 month period. 

The survey mentioned above took place in the lead up to the FE Select UK Growth event, which took place at The Grange Hotel, St Pauls. The fund selectors were joined by guest speakers Martin Walker from Invesco Perpetual, Mark Martin from Neptune, Chris St John from AXA Framlington, Schroders’ Paul Marriage and JOHCM’s Alex Saviddes. 

 

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