The IA UK All Companies sector saw the biggest net retail sales out of any other area of the market in March 2017, according to a report from the Investment Association, which industry commentators believe is largely justified.
This news may come as a surprise to investors, given the current uncertainty in the UK with the Brexit negotiations ongoing. (The snap general election wasn’t announced until the middle of April).
That said, the recent pullback in last year’s rotation from growth into value may have meant FTSE 100 stocks have become more attractive, given that many of its constituents are global-facing quality mega-caps. Increased expectations for inflation and global growth may have also bolstered the popularity of UK equity funds that invest further down the cap spectrum.
What is interesting to note, however, is that within the IA UK All Companies sector, tracker funds took in £596m in net retail sales, while active funds received just £328m.
It should also be noted that funds across the board saw significant inflows this year relative to history, with net retail and institutional sales increasing more than four-fold compared to March last year.
Source: The Investment Association
Chris Cummings, chief executive of the Investment Association, said: “We are now starting to see some signs of investor confidence returning following a period of reduced risk appetite in the context of geopolitical and economic uncertainty throughout 2016.”
Is the fact that this confidence is manifesting itself predominantly within UK equities incongruous with the current backdrop, or is it a positive sign of things to come for the home market?
Neil Shillito (pictured), fund manager at Downing, said: “Yes it’s illogical, but I think it’s probably part of a wider trend towards IFAs ‘outsourcing’ their investment decisions either through the use of multi-manager/multi-asset funds or, in this case, the UK All Companies sector. 
“’Why build a balanced portfolio of UK large, mid and small-caps when you can get the whole lot in one package’ appears to be the thinking.”
Overall, Shillito doesn’t believe this sudden rush of inflows into the sector should ring alarm bells for investors though and says it is simply a passing phase.
Adrian Lowcock, investment director at Architas, agrees that popularity in a sector alone isn’t enough to raise alarm bells and that overvaluations combined with a change in economic conditions would be needed to justify excess caution.
“UK equities are not necessarily cheap but with the weaker pound they still look good value to many overseas investors at the moment,” he explained.
“In the UK the impact of the Brexit vote continues to be felt amongst investors as it led to more QE, lower interest rates and a weaker pound, all of which contributed to a rally in stock market valuations.
“But there is more to things than just politics; the UK economy held up rather well, whilst the global outlook has improved significantly, particularly in the US and Europe.
“The improved economic outlook and weak pound has been the main driver for interest in the UK All companies sector amongst investors.”
Ben Gutteridge, head of fund research at Brewin Dolphin, agrees that the undervaluation of sterling has made UK equities attractive at this juncture. While Brexit negotiations appear to be acrimonious, he says there is empirical evidence to suggest that the market has largely adjusted to the UK government’s strategy.
“No doubt the consumer will be buffeted by higher levels of inflation, but some offset will be generated via the competitiveness of sterling amidst a regime where trading lines remain unchanged for at least another 22 months,” he pointed out.
“Though sterling has rallied fairly smartly off its lows, the discount versus the euro, and particularly the dollar, is too great. On that basis we support flows into the UK stock market.”
Performance of currencies vs US dollar over 1yr
Source: FE Analytics
Danny Cox, head of communications at Hargreaves Lansdown, says the increasing popularity of UK equity funds can also be attributed to the quality of companies available to investors across the cap spectrum.
“The UK stock market is home to many world-class companies, from international giants to a diverse array of smaller businesses,” he said. “A fund that invests in UK shares is also generally the first port of call for most UK-based investors.
“While they all have the aim of growing the value of investor's capital over the long-term, each can go about this in different ways, which gives investors and their advisers a wide range of choice in styles and approach.”
However, Chase de Vere’s Patrick Connolly warns investors of investing too much money after strong gains have already been made, especially with so much uncertainty on the horizon.
“While there is value in some UK stocks many others, particularly in so-called defensive sectors, are looking decidedly expensive,” he said. “So, those who are investing into the UK stock market need to think long and hard about the funds they’re investing in and the risks they’re taking.”
The fact this increased interest in UK equity funds has been mostly seen through trackers raises other questions, however. Last year’s sudden market rotation left many active UK equity investors floundering over the short term, with just 45 out of 261 funds in the IA UK All Companies sector managing to outperform the FTSE All Share index over the course of 2016.
Advocates of passives will argue that tracker funds are far cheaper and have indeed outperformed the average active UK equity fund over the last year. Meanwhile, concerns have been voiced by active advocates regarding the sudden increase in the use of passives, which has meant a small pool of the same stocks are looking increasingly over-owned.
According to the Investment Association’s report, tracker funds across the board saw a net retail inflow of £1.7bn in March, representing the highest level of sales since June 2013.
Their overall share of industry funds under management was 13.7 per cent, compared with 11.2 per cent in March last year.
“There’s a price war going on – a race to the bottom and the belief that cheap is bet,” Shillito said. “The active versus passive argument is skewed and centres on passive equating to ‘cheap’ which means ‘good’ while active equates to ‘expensive’ which is ‘bad’.”
While he doesn’t believe this poses a threat to active management, the fund manager says it will “sort the men from the boys”.
“This is a bloated and inefficient market which is great news for good, active managers,” he continued. “Don’t forget that Aldi and Lidl came into the UK market 20 years ago and were derided for being down-market until shoppers woke up to the fact that they were selling some really good products at half the price of their competitors, so then they started to eat into the market share of the big four.
“So guess what? The big four have responded and the erosion is slowing down.”
Lowcock believes the increased appetite for passives among UK investors is due to industry encouragement to be cost-conscious and the fact that many active managers don’t outperform the market.
“When markets are rising, a tracker fund is a cheap way to get access, but when they flatten or fall in value then active managers will be become attractive,” the investment director said.
Performance of sector vs index since start of data
Source: FE Analytics
“There should be a balance between active and passive for an efficient market. Whilst I don’t think active are threatened by passive funds, there is a chance that too much money goes to passives creating momentum-led markets. Active managers add value, but only the good ones and only if you are a patient investor.”
Gutteridge remains a keen supporter of the active management industry despite the fact passive funds continue to take market share as quarters of the active management world fail to meet client expectations.
“Of course this poses a threat to elements of the active management sphere and we would expect price adjustment and consolidation to be the natural response; something that is well underway,” he explained. “As it stands Brewin remain committed to finding competitively-priced, high-alpha product and are extremely satisfied with our achievements thus far.”
Cox adds that tracker funds are particularly popular with younger generations and those who are more cost-conscious.
“Investors should either choose good active managers where there is a good record of long-term outperformance, or opt for the low-cost tracker. There are too many funds and those that fall between the two should be avoided,” he warned.