A change in the bond yield, a Bank of England rate rise and a portfolio that has shifted towards financials and away from full-recovered domestics are some of the key reasons FE Alpha Manager Henry Dixon has outperformed this year after a difficult 2016. 
The manager of the four FE Crown-rated Man GLG UK Income fund said 2016 had delivered good returns for investors and plenty of opportunities for UK managers looking at valuations but investors were focused elsewhere.
“I think, pleasingly, post-Brexit there was the opportunity to invest in a lot of shares that were priced for quite a significant UK recession,” he said.
“That enabled us to buy challenger banks below book value and housebuilders on mid-single figure price-to-earnings multiples.”
Indeed, as the below chart shows, the domestically-focused FTSE 250 fell significantly further than the more international FTSE 100 following the EU referendum.
Performance of indices in 2016
Source: FE Analytics
However, the mid-cap index struggled to make up the returns by the end of the year as the fall in sterling and fears over the strength of the UK economy outside the EU sent investors into companies with overseas earnings.
The main issue in 2016 however was falling bond yields, which Dixon said was a problem for his bottom-up approach that focuses on valuations and balance sheet strength.
“We actually prefer it when the bond yield environment is a bit more measured and not constantly falling,” he said.
“As the portfolio is ostensibly cheaper than the market and with a better balance sheet, what you will find is when bond yields fall there is an element of balance sheet forgiveness.
The manager added: “Because the cost of borrowing debt is so unbelievably low people have, in certain places, been getting a little complacent with regards to ever increasing amount of debt in certain businesses.”
The reason for this is that in some instances the bond market isn’t charging corporates any interest rate at all for borrowing money, he explained.
“That is a highly curious state of affairs and one that I refuse to believe can last into perpetuity,” he noted.
This year however the fund has stormed back into favour, producing the best returns from the IA UK Equity Income sector year-to-date.
Indeed, as the below chart shows, the fund has more than doubled the returns of the sector average and the FTSE All Share benchmark so far this year, and Dixon said flat lining bond yields have been a big boost.
Performance of fund vs sector and benchmark over YTD
Source: FE Analytics
“We are in some great balance sheet shares on low valuations and as bond yields haven’t fallen this year there has been a slightly more measured debate in and around value,” he said.
An additional boost came in September, when the Bank of England decided to raise interest rates for the first time in a decade, and Dixon believes there could be more to come.
“There are arguments to be made that raising rates might not be too detrimental this time and I think one of the key reasons surrounds the fact that pension deficits are so sizeable and that is really hobbling economic growth,” he said.
“The UK spends a lot of money topping up actuarial deficits and I think this is having a direct impact on business development.
“If interest rates do rise and businesses feel they are in a situation therefore not to divert so much money to their pension funds but spend money on investment, then we might be surprised that interest rate rises might not be the negative growth event that historically they have been and if that unfolds then interest rates can clearly rise further.”
This should be a boost for Dixon’s fund as investors will begin to focus more on balance sheet strength while highly-leveraged companies could come under stress.
However, he warned that some investors have yet to move on from the Brexit vote last year, expecting his portfolio to remain invested in some of the unloved domestic stocks of 2016.
The manager said: “Housebuilders were a huge component of the portfolio in the wake of Brexit as vast swathes of companies were trading way below book value with net cash on the balance sheet and that was an incredibly good opportunity for us.
“However, we have pared back our housebuilder exposure of late because those very depressed valuations have corrected.
“I think we now have got to be honest with ourselves and say that a lot of issues like a UK recession have now been priced out of the domestic shares.”
Therefore it is no longer a case that managers can own domestic stocks on a broad basis and must instead look to valuations and balance sheets, a process that has seen the £289m Man GLG UK Income fund be the best performer in its sector under Dixon’s tenure.
Performance of fund vs sector and benchmark over YTD
Source: FE Analytics
“As I look domestically now one of our bigger moves recently has been back into life insurance where for years we have speculated that potentially the capital-side looks a bit concerning with regards to solvency directives coming in one after another,” he said.
“But in my opinion that is one area of the market that is probably exhibiting some of the best value, some of the best earnings momentum and that would be an area that we would move to domestically.
The manager added: “It is a combination of really good value, very good estimates momentum and I think we see some interesting things underway with a slight change in narrative on bond yields which we also think will be positive.”
This highlights how the portfolio has changed since last year, with sectors that were exhibiting value characteristics now fully valued.
“As I say it is important for people to realise that it is not the same domestic bets that we had on a year ago,” Dixon said.
The fund has a yield of 4.22 per cent and a clean ongoing charges figure (OCF) of 0.9 per cent.