The UK’s best alpha-generating funds over the past decade can be found in the IA UK All Companies despite the sector average failing to generate alpha against the FTSE All Share, data from FE Analytics reveals. 
Alpha is measured by a fund's over- or under-performance in comparison to its benchmark and represents the return when the benchmark is assumed to have a return of zero, indicating the value added by manager's abilities.
In a previous study FE Trustnet found that, on average, funds in the IA UK All Companies failed to generate alpha over the past 10 years, while those in the IA UK Equity Income sector had.
However, a deeper delve into the sectors reveals that some of the best funds for alpha generation are in the IA All Companies sector, although it is also home to some of the worst.
Over the last 10 years, the average UK All Companies fund has generated 12 basis points less alpha than the FTSE All Share, despite more than half of funds (114 out of 195) generating positive alpha.
Simon Evan-Cook, portfolio manager at Premier Asset Management, said: “It doesn’t surprise me at all. I’m actually, if anything, surprised it is as close to the index as it is.”
He says there are three main areas weighing on the alpha generation ability of the sector – and all three are related to passive vehicle performance.
Having run a similar study three years ago, he says that the sector is a “hodge-podge” of various funds.
“There were big subsections that are places that no investor should have their money. I’m thinking now specifically there are a number of expensive trackers which I was surprised at – it was the worst category,” Evan-cook (pictured) said.
“Funds that were openly saying they were trackers but were still charging active fees. Clearly that is only ever going to lead to negative alpha and quite substantial negative alpha over the long term.
“There are also a lot of closet trackers which again are charging active fees for what effectively is a tracker that is masquerading as an active fund - and they take up a lot of alpha and obviously underperform over longer time periods as well.
“Then you also just have plain trackers in there and they are not going to provide positive alpha. So it doesn’t surprise me that the average UK fund has underperformed.”
The sector has a wide spread between the top and bottom alpha generators, with MFM Slater Growth generating 8.37 while Aviva Investment UK Equity MoM 2 was -7.53.
Performance of funds vs sector and benchmark over 10yrs
Source: FE Analytics
While there are a number of trackers in the bottom half of the sector, Evan-Cook says there are also some “badly run active funds”, however, that should not deter investors from active managers.
“You are taking a risk if you buy an active fund and get it wrong. [If] you get a manager with a bad process or a manager with a good process who doesn’t stick to it or has bad judgement then you run the risk of being a long way beneath the benchmark.
“So I would always expect to find in any sector at the bottom of that sector a badly-run active fund – they exist there’s no point in pretending they don’t – it’s our job to avoid them.”
The fund he uses as an example of a top performing portfolio is the £1.8bn JOHCM UK Opportunities fund run by FE Alpha Manager John Wood.
He says he has bought and held the five crown-rated fund in his portfolio since 2008 and likes the high level of alpha (4.19) it has achieved.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
As the above shows, the fund has returned 114.05 per cent over the last decade, 44.17 and 47.14 percentage points ahead of the FTSE All Share and IA UK All Companies respectively.
“It’s done a great job and has certainly put a lot of daylight between itself and the market over that time period,” the manager said.
“It’s a highly active fund, the manager doesn’t care about the index, looking at fundamentals, valuation driven. All this stuff we love and effectively broadly speaking the only type of manager we will consider holding and it’s done a fantastic job for us.”
Mid-caps funds generally dominate the top quartile, as the FTSE 250 has had a very strong run in the last 10 years and make up a lower percentage of the All Share.
Indeed, the FTSE 100 – the largest 100 stocks in the UK market - makes up around 80 per cent of the index, with the rest coming from the mid- and small-cap sectors.
Evan-Cook said: “You would find those would have very high active share versus the FTSE All Share so again that would come into that category that to beat the index after charges you have to look very different to the index. It doesn’t surprise me that the mid-caps have outperformed.”
The FTSE 100 is a horrible index full of companies that have become too large or sectors that have become too large in the last 10 years.
“You’ve got the FTSE 100 being dominated by banks at the start of the period and by mining companies in the middle of that period and both of those have had some pretty horrible times. So by not having as much as the skewed FTSE All Share index in bad sectors you’ve done alright.”
Laith Khalaf, senior analyst at Hargreaves Lansdown, added: “What you are getting there is a double-whammy, in that, mid-caps themselves have outperformed over that period so you are getting a boost from that.
“But then also the market is less efficient the further down the cap scale you go so there’s more scope for managers to bring their research and analysis to bear.”
In comparison to the IA All Companies sector, the average fund in the IA UK Equity Income sector has achieved positive alpha generation (0.11) over the last decade.
With fewer funds in the sector (46) the spread between the best and worst alpha generators is smaller. The Unicorn UK Income generated alpha of 5.54 compared with Scottish Widows UK Equity Income which was 3.43.
Khalaf said: “The UK Equity Income universe is smaller in terms of the amount of stocks they are going to invest in so that in itself leads to a smaller dispersion of returns.
“I also think there is a more restricted number of strategies within the UK Equity Income. The UK All Companies sector has growth, value, aggressive, defensive, large-cap, mid-cap whereas in UK Equity Income funds the strategy tends to be more homogenous.
“The combination of those two things means dispersion between funds should be lower within the UK Equity Income sector.”
Performance of funds vs sector and benchmark over 10yrs
Source: FE Analytics
Premier’s Evan-Cook adds this lower downside is due to some natural disciplines imposed on managers in the sector.
“Equity income itself sets a discipline on the managers – a valuation discipline – in that if a stock becomes too expensive that means that the yield has dropped and therefore you can’t hold it anymore.
“Holding onto stocks that are too expensive is one of the main factors that can cost active managers sometimes.”
Additionally, he says that these funds have had a quality growth bias as they have keyed in on companies that are able sustain and grow their dividends.
“If you’re doing the job properly then you are looking for companies that can sustain their dividends and so you are analysing quality of companies,” Evan-Cook said.
“You should be putting in there a quality bias which has been quite a good thing to have, particularly over the last seven years.
“Just to be in that sector there are some disciplines that are automatically imposed on you that aren’t necessarily imposed on a UK All Companies fund.”
The fund generating the highest level of alpha is the mid- and small-cap focused Unicorn UK Income fund run by FE Alpha Manager Fraser Mackersie and Simon Moon.
Also among the top performers are more large-cap biased funds including Trojan Income and Threadneedle UK Equity Income, though they also have an overweight position in mid-caps.
Khalaf said: “Most managers will be more tilted towards those medium and smaller stocks compared to the All Share but obviously the funds with a specific focus on mid-caps are even more so.”
He says these managers, which have proven to be good stockpickers at both the large- and mid-cap level are “what we look for in an active manager”.