Any ‘artificial’ gains made from currency effects on the FTSE 100 should be locked in and investors should now look to explore further down the cap spectrum, according to AJ Bell’s Ryan Hughes (pictured). 
The head of fund selection says that, given more than 70 per cent of earnings come from overseas, the weakening of sterling post-Brexit has been the main contributor to the FTSE 100’s strong performance.
Given that this currency trend won’t last forever, he says it could be prudent to hedge some UK blue-chip exposure and look at funds which hold the more attractively-valued domestic-facing companies.
Performance of indices in 2016
Source: FE Analytics
“Everyone’s initial thought with Brexit was that it was going to be dreadful and that the world would stop turning and of course, when rational thought sets back in – are people going to stop trading with us? No,” he said.
“If you’re a world-renowned engineering company and you’re based in Britain and if you’re number one in your field, people will still trade with you. They’ll still want your product. Some things don’t change.
“I think what hasn’t changed is that good quality businesses which are well-managed, have got pricing power and are innovative will do well. That’s been true forever and I don’t see why that should change now.
“The FTSE 250 is the market area that has been lagging the most because of currency. If I took a long-term view, where would I most likely invest? It’s got to be down the cap scale. It’s not going to be in the FTSE 100 forever because it has those inherent problems.”
In the below article, Hughes talks through three funds run by highly-experienced managers that he believes can successfully navigate the lower cap space of the UK market.
FE Alpha Manager Richard Watts’ Old Mutual UK Mid Cap is £2.1bn in size and has a concentrated portfolio of 41 holdings. Its largest weightings include the likes of Paysafe, Just Eat and Micro Focus, although holdings tend to be fairly evenly-weighted and each individual stock cannot account for more than 5 per cent of the portfolio.
Hughes said: “The team at Old Mutual has probably always been the market-leading mid-cap team in terms of the quality of the people there, their experience and their tenure – it’s a team I really like.”
Watts aims to provide growth through a combination of macroeconomic research and bottom-up stock selection – he looks for which individual companies look the most attractive based on market cycle positioning. His top-down considerations include inflation outlooks, potential interest rate movements and economic growth prospects.
Since Watts began running the fund in December 2008, it has returned 327.69 per cent, outperforming its sector average and benchmark by 183.24 and 32.2 percentage points respectively.
Performance of fund vs sector and benchmark under Watts
Source: FE Analytics
The fund has historically struggled during falling markets, having underperformed its average peer in 2007, 2008 and 2011. As such, it has a bottom-quartile downside risk ratio and maximum drawdown over Watt’s tenure.
However, it is in the top quartile for its returns during seven out of the last 10 years.
Old Mutual UK Mid Cap has a clean ongoing charges figure (OCF) of 0.85 per cent and yields 1.03 per cent.
Standard Life Investments UK Smaller Companies
Next on Hughes’ list is FE Alpha Manager Harry Nimmo’s Standard Life Investments UK Smaller Companies fund, which was launched back in 1997.
The £1.3bn fund currently has a portfolio of 56 holdings, 52.4 per cent of which are UK mid-caps. Some 15 per cent is then allocated to FTSE Small Cap stocks and the remaining 32.3 per cent are in stocks that aren’t listed in the FTSE 350 index.
As with other Standard Life Investments funds, the manager adopts the firm’s ‘Focus on Change’ policy, which aims to capitalise on market inefficiency when a company is undergoing a period of structural change.
Nimmo looks for companies that offer strong cash flows, recurring revenues and the ability to become the UK large-caps of the future. Examples of the fund’s largest holdings include biotech firm Abcam, food wholesaler Cranswick and Domino’s Pizza.
Over the last decade, the fund has outperformed its average peer in the IA UK Smaller Companies sector by 61.17 percentage points with a total return of 165.19 per cent.
Performance of fund vs sector over 10yrs
Source: FE Analytics
Over this time frame it is in the top quartile for its maximum drawdown and Sharpe ratio, which measures risk-adjusted returns. Even though small-cap funds tend to be more volatile than those that invest in large-caps, the fund’s maximum drawdown is broadly in line with that of the FTSE All Share’s (which it isn’t benchmarked against) and its Sharpe ratio is twice as high.
Standard Life Investments UK Smaller Companies has a clean OCF of 0.99 per cent and yields 1.1 per cent.
The final fund on the list is Montanaro UK Income, which has been managed by Charles Montanaro since the end of 2012.
Over this time, it has outperformed its average peer in the IA UK Equity Income sector by 18.07 percentage points with a total return of 60.97 per cent.
Performance of fund vs sector under Montanaro
Source: FE Analytics
Had an investor held £10,000 in the fund over this time frame, they would have received £1,771.72 in income alone.
Hughes said: “Looking outside of the big, mainstream names there is Montanaro UK Income, which is a small-cap specialist but with an income slant.
“There’s a lot of yield further down the cap scale. You also have to be smarter about where you invest in this market.”
The £144m fund has a concentrated portfolio of 49 holdings which have a median market cap of £414m. its largest portfolio allocations include Jupiter Fund Management, Taylor Wimpey and St James Place.
While it invests predominantly in quoted UK companies, it can hold up to 20 per cent of its portfolio in in EU-quoted companies and has small regional weightings in Italy, Sweden, Switzerland and Spain.
In terms of its risk metrics, Montanaro UK Income is in the bottom quartile for its downside risk and annualised volatility. It is also in the third quartile for its maximum drawdown, which suggests it may not be best-suited to very cautious investors.
Montanaro UK Income has a clean OCF of 0.34 per cent.