Stephanie Flanders: Why UK equities don’t reflect the overall economy

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Written by: Stephanie Flanders, Alex Dryden
11/12/2015
Domestic equities have long been dominant in UK investors’ portfolios and there is little sign of that changing, yet investors might be surprised to find their UK equities holdings may not reflect the underlying UK economy.

Invest in the FTSE 100 today, and you are likely to find any improvement in UK earnings drowned out by global earnings trends. This select group of large UK companies obtain only above 20% of their revenues from the UK, on average.

Another quirk of the UK equity market is its high concentration. FTSE 100 companies account for about 80% of the market value of the FTSE All-Share, and the top 25% of stocks – ranked by size – account for nearly 90% of the market.

This concentration has weighed on the long run performance for the FTSE All-Share, as the small and mid-cap sectors have consistently outperformed in recent years. Accessing that outperformance would clearly be difficult in a passive FTSE 100 tracker, but UK active fund managers have been able to take advantage.

In fact, a UK fund manager needed to generate an excess return of 5.7% annualised (net of fees) to be in the top one quarter of funds in the IA UK All Companies sector over the past three years – much higher than in continental Europe or the US.

As the percentage of outperforming stocks has risen, so have the excess returns of this top quartile of UK funds, which is almost entirely owing to the large declines in the value of oil & gas and mining companies.

It is probably too soon to call the end of the downturn for the commodity bear market, but a bottoming within the next 18 months seems more likely than not. That, in turn, would suggest an end to the underperformance in these sectors, and the end of this easy route to outperformance.

Investors considering their UK equity holdings need to also keep risk in mind. According to the Investment Association, 28% of active funds in the UK All Companies sector held 40 stocks or fewer in the third quarter of 2015. Depending on the stocks, concentrated holdings could leave investors exposed to individual company risk.

With individual stock returns and valuations now more dispersed, there is still plenty of scope for active managers to outperform in the next few years. But the past few years in the UK have been unusual, in that the consensus trade has also delivered great outperformance against the main equity benchmarks.

When the tide finally turns for commodities, this era will come to an end and the focus will shift back to all the old-fashioned drivers of outperformance: research-driven individual stock views, portfolio construction and risk factor management. Some managers will handle the change a lot better than others.

Stephanie Flanders is chief market strategist for Europe and Alex Dryden is global market strategist at JP Morgan Asset Management

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