Many commentators have attributed the underperformance of nine out of 10 active UK equity funds in 2016 to their managers misjudging political events but there is another explanation – their tilt to growth stocks
The demise of active investing was once more trumpeted this month after stockmarket index provider S&P Dow Jones Indices published analysis showing – as the headline of one Financial Times article bluntly put it – 87% of active UK equity funds underperformed in 2016. As the piece went on to note, this was a fourfold increase on the previous year, when less than a quarter (22%) of active UK equity funds underperformed.
So what happened? In the opinion of both the Financial Times and S&P, the most obvious explanation was that “many investment managers were wrongfooted by unexpected political developments last year”. As a spokesman for the latter told the paper: “The Brexit vote and Donald Trump’s election victory may have caught many managers off-guard.”
It is certainly an explanation – the problem being, it relies on the sometimes-justified idea of active fund managers spending their lives merrily ‘betting’ on how particular events will turn out as opposed to positioning their portfolios to cope with a range of possible outcomes. Still, if it was not hundreds of fund managers misjudging politics events, what else might explain this widespread underperformance?
A different perspective
Here on The Value Perspective, as we have observed in pieces such as End of story, we are wary of easy explanations and simple narratives because they only highlight one possible version of the future when, of course, there are so many others that could each play out instead.
Nevertheless, we cannot help but be struck by the near-coincidence that, last year, not only did 87% of UK active funds underperform the index but, as the following chart shows, 91% of all funds under management in Morningstar’s UK All Companies sector had a greater than 50% bias to growth (as opposed to value).
Style split of UK funds under management*, UK All Companies sector.
Source: Schroders, Morningstar Direct, report date: January 2017, *based on IA UK All Companies Sector, using fund data available at 30 November 2016. Excludes funds with no style score available.
Clearly the fact the proportions are so close is, as we say, just coincidence and yet it is indicative of a certain mindset that held sway among the great majority of UK equity fund managers last year. The end-result being of course that, with nine out of 10 UK equity fund managers positioned towards growth stocks in 2016, in what happened to prove a very good year for value they naturally did very poorly.
Some underperformance was driven by volatility in financial stocks, the FT article suggested, explaining: “Financials performed badly in the first half of 2016 before recovering strongly in the second half in a shift that was not anticipated by many UK managers.” It added: “Oil and mining companies, which were out of favour with many portfolio managers at the start of 2016, also staged unexpectedly strong rallies last year.”
Not anticipated? Unexpectedly strong rallies? As regular visitors to The Value Perspective will be aware, we have been extolling the virtues of financial, oil and gas stocks for some time now. Why? Because they have been among the cheapest sectors in the market – a quality that is of great interest and importance to value managers, if less so to their more growth-oriented counterparts.
Might the underperformance of so many active UK equity funds last year have less to do with Brexit and Trump and more to do with their pronounced tilt towards growth?
That being so, might the underperformance of so many active UK equity funds last year have less to do with Brexit and Trump and more to do with their pronounced tilt towards growth? After all, this would also help explain the significant outperformance of so many active UK equity funds in 2015 – a year when growth had a very good year and value a very poor one.
As the FT and S&P might archly respond, it is an explanation – and one others than The Value Perspective are better qualified to analyse in greater detail. Where we would be more assertive, however, is on the need to avoid thinking about investing in 12-month chunks. Whilst past performance is no indication of future performance, more than a century of data points to a value strategy outperforming over the long term – say, five years – while the performance (bad and good) of growth funds in the last two calendar years can be explained by their inclination to own expensive assets. Regardless of what happens in random single years, over the long term such an investment approach, in our opinion, will not work.