All-cap funds with a high weighting to mid-caps could be doing investors a ‘disservice’ as they are not providing as broad a portfolio as might be expected. 
Data from FE Analytics shows that funds in the IA UK All Companies and UK Equity Income sectors have a more closely-linked relationship with the FTSE 250 than they do the FTSE 100.
The average r2 figure for all UK funds to the FTSE 250 is 0.72, compared to the FTSE 100 which has a score of 0.65.
R2 represents the percentage of a fund portfolio's movements that can be explained by movements in a benchmark index – i.e. how correlated its performance is to the benchmark.
Charles Younes (pictured), portfolio manager at FE Research said: “It’s quite high - 72 per cent of the performance is explained by the FTSE 250 so 28 per cent is explained by something else like stockpicking.
However, he adds that there are mid-cap only funds within the IA UK All Companies sector that may distort these figures slightly.
Overall, Martin Bamford, managing director at Informed Choice said: “Investors need to understand what they are getting for their money.
“There’s nothing inherently wrong with a sizeable allocation to mid-caps, which are often supported by lots of merger and acquisition activity.
“The FTSE 250 has a long-term track record of outperformance, beating the FTSE 100 in most bull markets during the past thirty years.”
Indeed, slightly more recently, the FTSE 250 index has outperformed its larger peer by 54.69 percentage points over the last decade, and has been ahead over one, three and five year periods.
Performance of indices over 10yrs
Source: FE Analytics
FE Research’s Younes said: “Over the last few years managers have been very positive on the UK domestic economy more than the international market with the global emerging markets slowing down and the open political issues.
“There are new companies in the FTSE 250 that are not very actively researched, the valuations are okay and they’re disturbing the big companies so everything looks good for an active manager.
“On top of that if you look at the composition of the FTSE 100 the index is still full of miners, commodity-related stocks and banks that you didn’t want to touch over the last few years.
For all these reasons UK equity managers moved into the FTSE 250. Neil Shillito, a fund manager at Downing LLP, added: “I think there is almost certainly an element of moving down the scale in order to drive performance.
He says whether the market is over-reliant is quite difficult to discover, but adds that he thinks it is certainly reliant to some extent for its performance.
“If the fund is genuinely all-cap then the majority of its stocks by weighting should already be in the FTSE 100 and no rotation necessary, but then all is not necessarily what it seems in the world of investment,” he explained.
Indeed, FE Research’s Younes points to the Brexit vote last year as an example of when this rotation into the mid-caps hurt fund managers.
“You pay them to do your market cap allocation but last year you can blame them because while you paid them to do this but you didn’t pay them to take on political risk,” he said.
“What happened was going into the Brexit referendum all the managers knew that buying into the mid-cap space would make them ‘long’ the remain vote and ‘short’ the Brexit vote.
“So if there was a Brexit vote then they would be exposed to this political risk and none of them took this into consideration or hedged this risk and in the end in June every active manager failed to protect from the downside.
“And if you look at the performance in 2016, because they were all in these mid-cap names they have all underperformed the FTSE 100 because they took that political risk and did not hedge it.”
Performance of indices from the EU referendum to year-end
Source: FE Analytics
Overall, Informed Choice’s Martin Bamford said: “If you are picking a fund because of its all-cap exposure and ability for the manager to make active selections, then defaulting to mid-caps as a long-term position could be doing investors a disservice.”
However, Rob Burdett, co-head of multi-manager solutions at BMO Global Asset Management says it is unclear whether this correlation to mid-caps is through stockpicking or beta.
In fact, he says dedicated mid-cap funds are more likely to benefit from mid-cap beta than all-cap managers.
“If you look at mid-cap funds in theory they are looking at 250 companies – though most of them extend to the promotion and demotion area as well and sometimes beyond that and there are only 30 to 80 of them – so they’re owning a fair proportion of their benchmark (the FTSE 250) by number of name.
“In a lot of mid-cap fund basis it is the mid-cap beta that is the driving force,” he said.
In the all-cap space, he says you could have a situation where the alpha is all coming from mid-cap beta but could also be down to good stock selection or allocation.
“I don’t think they are mutually exclusive points but you definitely need to be aware that it could not be skill,” said Burdett.
However, don’t expect this trend of overweighting mid-caps to slow down anytime soon, warns the multi-manager.
“In general terms over the long-run I think any active manager if they like BP and not Shell, if they like HSBC and not Barclays, you are already immediately underweight the FTSE 100 just by those decisions,” he said. “By absenting two of the top 10 big stocks just from a relative point of view because you are unlikely to have a full overweight the size of the second-largest oil company or bank these days.”
FE Research’s Younes added: “I guess this is likely to continue because you have more stockpicking opportunities on the FTSE 250, you have more new companies coming than the FTSE 100 which is pretty much the same index every time.
“The FTSE 100 is also typically more covered while in the FTSE 250 you still have some companies that are not very well covered by sell-side analysts. By definition an active manager will try to benefit from these market inefficiencies.”
As part of an ongoing series, next we will lift the lid on those funds with an overweight bias to mid-caps that are outperforming the FTSE 250, those with a low dependency to mid-caps outperforming the FTSE 100 and the mid-cap dedicated funds that are better at playing the sector than a tracker.