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Fund manager view: why it’s time UK equity investors check what they are buying

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After a strong run of performance over the past decade, JP Morgan’s Alex Dryden says signs of a turning tide may indicate that it’s time to assess whether to move out of UK small and mid cap stocks.

The UK equity investment landscape has been shaped by two major trends in the last 10 years: the outperformance of small and mid-cap stocks, and the underperformance of commodity sectors.

Both trends might be on the cusp of beginning to retrench, posing significant potential consequences for UK equity funds. Top decile UK fund managers in 2015 had, on average, a 75% allocation to mid and small cap stocks. Now is the time for investors to assess whether they are comfortable with taking on such a heavy overweight to mid and small cap stocks.

In the last decade, the relative strength of the UK’s fast growing economy helped fuel outperformance in more domestically exposed mid and small cap equities versus the internationally exposed large caps. At the same time, commodities oversupply and a drop in Chinese demand have triggering a protracted commodities bear market, resulting in a disproportionately large impact on the performance of UK large caps, as commodity-related names made up over 30% of the index in 2008. Today, their weighting has halved to just 16%.

In response to these trends, UK active fund managers have adopted a consensus trade of underweighting commodity stocks and going heavily overweight small and mid-cap companies, helping the top quartile of active managers to outperform the benchmark by approximately 6% on an annualised basis over the last three years, considerably more than their US and European peers.

The best-performing 10% of UK active fund managers have, on average, a 75% allocation to the small and mid-cap stocks and just a 7% weighting to commodities. To put this in perspective, the benchmark has a 20% weighting to small and mid-cap stocks and a 16% exposure to commodity sectors. But what happens if the tides start to turn?

After eight years of consecutive declines, commodity markets are finally showing signs of approaching a bottom. As commodity prices have rallied, materials and energy have been the top performing UK equity sectors in 2016, presenting a challenge to many of the best-performing fund managers that have long-held underweights in the sectors.

Meanwhile, a weaker pound could herald another change of dynamics in the UK equity space, as the strength of sterling has weighed down large cap UK companies sourcing approximately 75% of their earnings overseas. As it is now weighed down by Brexit fears, a weaker sterling may translate as good news for large and mega caps.

A third factor that could trigger a change in the UK equity market is the relative valuation of small and mid-cap stocks versus large caps. The outperformance of small and mid-cap companies since the financial crisis has pushed relative valuations to stretched levels. Investors should be mindful of the growing potential for a reversal.

The changes in market leadership so far this year have caught many active fund managers off-guard. In 2015, 79% of active fund managers were able to outperform the FTSE All-Share. In 2016 to date, only 21% of managers have outperformed the benchmark as the stronger pound, rebounding commodities and stretched valuations have weighed on performance.

The top decile of fund managers in 2015 are registering some of the worst performance in 2016. Those managers who were in the top decile in 2015 are now on average 79th percentile over the year to date. Meanwhile, managers who held positions that were out of favour last year, such as overweights in commodities and large cap, are experiencing some of the best performance: those who are in the top decile year to date were, on average, in the 82nd percentile in 2015.

Some fund managers may be reluctant to call time on trends that have worked for them in four of the last five years. This behavioral bias could mean that managers hold onto their mid and small cap positions longer than is optimal.

Even if they are willing, many UK fund managers have spent nearly a decade building up their small and mid-cap allocations. Unwinding these positions in the relatively illiquid small and mid-cap parts of the market is likely to be challenging.

On balance, a rotation in market leadership is likely to have implications for fund performance and could drive up market volatility. It may be premature to call the end of the commodity bear market, but the reality for UK equities investors is that they should be assessing whether they are still comfortable with top active fund managers having a 75% exposure to UK mid and small cap equities.

Is it time to think about making a change in your UK equity allocation?  Signs of turning tides suggest it could be prudent to consider the question sooner rather than later.

Alex Dryden is a global markets strategist at JP Morgan Asset Management