The strategy makes a lot a sense as the majority of experts recommend that yield-seeking investors should diversify their income stream and shouldn’t be over-reliant on the FTSE’s largest dividend paying companies.
However, before investors decide on which fund they should choose, we ask the experts what the major risks are if an investor were to buy a multi cap income fund now.
They could fall over the short-term
Very few would disagree that mid and small-caps will outperform their larger rivals over a long period of time, but a number of experts have voiced concerns that, having rallied hard over recent years, smaller companies could well struggle over the next year or so.
According to FE Analytics, for instance, CF Miton UK Multi Cap Income Unicorn UK Income, PFS Chelverton UK Equity Income and Marlborough Multi Cap Income – all of which have a strong mid and small-cap bias –have been the IMA UK Equity Income sector’s four top performing funds over the last two years.
On top of that, those four funds–on average – returned 42.9 per cent in 2013 while the FTSE All Share returned 20 per cent.
However, following that strong performance and a weakening appetite for risk, there has been a trend among investors to rotate into larger, more defensive companies, in recent months.
This has hurt multi cap income funds, with those same four portfolios underperforming against the sector and the All Share over the last three months.
Performance of funds versus sector and index over 3 months
Source: FE Analytics
Richard Scott (pictured), who manages the PFS Hawksmoor Distribution and Vanbrugh funds, says that while small and mid-caps should outperform over the long run, he has been trimming his exposure to multi cap income funds recently as they could well continue to lose out on a relative basis over the short-term.
“There is a bit of an issue in the UK market as large-caps have underperformed so much against small and mid-caps that there is always going to be a natural bounce back in performance,” Scott said. “Although I don’t think it will be too long-lasting, the relative valuation of small and mid-caps moved too far, too fast.”
“Obviously, they have performed fantastically over the last few years, but if you were to step back 18 months or so you would have been buying companies that generate faster earnings growth and that comparatively undervalued.”
“That’s not really the situation at the moment as they have re-rated a lot and I think they will continue to underperform for a while.”
Not many have a long track record
In a recent FE Trustnet article, a number of industry experts – such as Hargreaves Lansdown’s Mark Dampier –warned that investors have been piling into top-performing multi cap income funds that haven’t been tested in a downturn.
For instance, the likes of MFM Slater Income, CF Miton UK Multi Cap Income and Marlborough Multi Cap Income have all attracted a lot of inflows but have been launched within the last five years and have therefore not witnessed a full market cycle.
History has shown that mid and small caps tend to fall further during times of market weakness and that has certainly been the case for those multi cap income funds that have a longer track record.
Two examples are PFS Chelverton UK Equity Income and Unicorn UK Income. While they have both been two of the best performing funds in the sector during bull markets – such as 2009, 2010, 2012 and 2013 –they has underperformed considerably when the wider market has fallen.
Performance of funds vs sector and index between Jan 2007 and Dec 2008
Source: FE Analytics
Our data shows, for example, that between 2007 and 2008 the Chelverton fund lost a hefty 53 per cent and the Unicorn fund lost 39 per cent while the FTSE All Share and the sector fell less than 30 per cent.
Size can be a real issue
Given the nature of the asset class they invest in, the size of multi cap income funds can be a risk, according to Premier’s Ian Rees (pictured).
He says that if a multi cap income fund wants to invest in the smallest constituents of the index and are attracting a lot of inflows, they will either have to close the fund or change their investment style – either by increasing the amount of holdings or by investing in larger companies – to deal with liquidity. A number of the sector’s multi cap income funds have grown substantially over recent years, as the table below demonstrates.
Source: FE Analytics
Rees, like the majority of industry experts, firmly believes that size will ultimately impact on performance and therefore he says this is something investors need to keep a very close eye on.
“I guess the classic example is that Neil Woodford used to run a multi cap income fund, but given the massive size of his Invesco Perpetual funds, he just had a long tail of smaller companies which didn’t have a meaningful impact on performance,” Rees said.
“There is nothing worse than buying a fund for a certain reason and then finding out a couple of years down the line that the manager has had to change his or her approach.”
There aren’t many out-and-out multi cap income funds in the sector
The issue of size also leads to the next possible risk, which is that investors don’t have a great deal of choice when it comes to a genuine multi cap income funds.
While there are a variety of funds that invest across the UK’s mid and large-caps – such as Old Mutual UK Equity Income, JOHCM UK Equity Income, Majedie UK Income and Royal London UK Equity Income – there are only a few funds that will, or have the ability to, invest in the smallest parts of the FTSE AIM and Small Cap indices.
For instance, Gervais Williams and Martin Turner decided to soft-close their CF Miton Multi Cap Income fund last year due to concerns over capacity.
Combined with their mirror close-ended fund, their multi cap income strategy was around £600m and Williams told FE Trustnet at the time that, if they were to be running any more money, they would be unable the buy some of the smallest companies that had helped them outperform in the first place.
Unfortunately, apart from a select few, the majority of multi cap income funds are reaching that size or have already grown past that level.
For instance, John McClure recently told FE Trustnet that while his strategy for picking stocks hasn’t changed, the growing AUM within his Unicorn UK Income means he can no-longer hold some of the micro caps that he used to.
