Volatile markets often deliver some painful lessons for investors on portfolio strategy and risk. 
And in these conditions a few investment stories finally let down their believers. Last year shattered faith in the commodity supercycle and in the magic of emerging markets. It also brought a reality-check for investors in index funds and many other passive vehicles.
Market indices in 2015 were a poor guide; the environment afforded ample opportunity for stockpicking.
It was a year that highlighted the benefits of focusing on individual company analysis and business fundamentals rather than being a slave to indices. The statistics suggest that the higher cost of this work in active funds was a price worth paying.
Not just in terms of absolute performance, but also measured by volatility and risk.
Performance of UK active funds versus index in 2015
Source: FE Analytics
Investors have been surprised to find how much commodities mattered in index portfolios. Although mining is not a major part of the UK economy, the sector was and still is over-represented in the UK stockmarket indices, creating additional volatility in the indices.
These pressures highlight the attractions of active funds that can side-step much of the risk in mining and oil. There has also been greater opportunity to find growth in the FTSE 250, compared with the largest FTSE 100 companies.
Away from the index heavyweights – which typically capture more of the global problems – there has been good progress over the last 12 months.
UK mid-cap companies, in particular, have delivered some strong performances. In contrast, recent years have shown persistent underperformance in some of the very largest companies. Poor executive incentivisation appears to be a factor in the failure of many of the largest companies to deliver shareholder value.
For active investors, a long term tilt against mega caps may be justified.
Performance of indices in 2015
Source: FE Analytics
The biggest global businesses dominate the indices and passive funds, and size gives the illusion of safety. But do the labels “quality stocks” and “blue-chips” really mean much?
There is a price for this respectability. The false comfort of these reassuring labels can draw in the unwary. Private investors may give undue weight to scale and history as a substitute for research. Passive funds and ETFs do not undertake fundamental research. Both groups can miss the risks in the biggest companies.
There is real uncertainty about the future of some major businesses and brands.
In banking, for example, new entrants are more flexible, have no legacy issues and can quickly dismantle long-established ways of doing things. Recognising potential disruption in sectors should be an important part of today’s investment process.
Big companies need additional scrutiny. As incumbents, they are often targeted by new entrants. Yet, they often lack the agility of the challengers, and struggle to respond to rapid change.
Investors should start to question the risks that come with passive investing. From time-to-time indices become dominated by specific, sometimes risky, sectors to an extent that far exceeds their economic importance. In 2000, this was technology, and in 2008 banking and financials dominated indices.
These distortions usually unwind, but the process can be painful.
The big investment theme of 2016 may not be new. Globally, the disinflationary pattern seems likely to persist. It is triggered by weak productivity growth, resulting from a lack of opportunity for productive investment around the world.
There is no sign that capital goods demand is suddenly going to pick-up, making it likely that the global pattern of anaemic growth and low inflation will continue. Devaluations of emerging market currencies are a symptom of low global inflation, but also act to transmit and worsen that disinflation.
Investors should focus on shares of businesses with genuine underlying growth and some potential for self-help.
In each of the last three years, many of the most volatile shares have ended amongst the best performers. It shows the anxiety of some investors, and also the importance of a consistent investment strategy and patience.
Investors underestimate the determination of politicians to stimulate growth, resolve international frictions and stabilise the global economy. There are good growth prospects in many mid cap businesses, with exposure to the UK consumer and the recovering Eurozone economy.
Indices with over-representation of volatile sectors appear a poor guide for risk management. Investors need to focus on individual company prospects and accounts analysis.
They need a real-world understanding of value and risk, rather than simply relying on indices.
Colin McLean is co-manager of the SVM UK Growth fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
