The FT reported recently that “stockpickers show signs of turnround after lagging behind markets”, based on data showing that 54% of active funds had outperformed the UK equity market. This represented a ‘turnaround’ from the just 22% which outperformed in 2016. Based on a dataset used by the FT from Standard & Poors1, 40.4% outperformed over three years, 45.9% over five years and just 24.8% over 10 years.
We take a deeper look at the statistics, whether this outperformance trend may continue to recover, and whether this ‘bet’ is worth taking.
How has the UK market performed?
Firstly, let’s take a brief look at how the UK market performs. As in many markets, large, medium and small companies can perform quite differently.
As a generalisation, large companies tend to be more international, whereas small companies tend to be more domestic. There are also differences in sectors – the UK has a high exposure to banks and energy in the large company segment, and more industrial companies in the smaller company segment. So, factors like exchange rate movements can have a more pronounced impact on larger companies than smaller ones, for instance.
The chart below shows the return and volatility (a measure of risk) of these different segments over the past ten years (2008-2017). We have used segments from data provider MSCI, where UK large companies are currently the largest 37 firms, medium the next 65 and small the next 2622. By MSCI definitions the combination of the mid and large companies corresponds very closely to the more widely known of the FTSE indices – the FTSE 100 index – whereas small broadly corresponds to the FTSE 250 index, normally called ‘mid-caps’.
As can be seen in the chart, the smaller the company, the higher the return – but risk is higher too. Still, over the ten year period, small company shares delivered a return that was double that of large companies per unit of risk3.
Given the marked difference in performance between companies of different sizes, how stockpickers allocate to this size factor, can have a pronounced impact on returns.
How are active funds performing?
From our analysis of active funds since 2007 we estimate that stockpickers have consistently over-weighted exposure to smaller stocks, in relation to the size of the market4. That the typical stockpicker overweights smaller companies makes sense: given the dominance of very large companies in the market, to take an active position requires moving away from these large companies – or alternatively being even more concentrated in a few companies, reducing diversification5. Moreover, smaller company earnings have grown faster than the large company earnings.
So, it is not surprising that the percentage of stockpickers beating the UK stock market is highly linked to the divergence between the returns of large companies and that of small companies.
In the scatter below we have compared the divergence between the return from small companies in excess of large (x-axis), with the percentage of active managers outperforming in each quarter from 2007-2017. When we look at the 44 financial reporting quarters during the decade, active managers on average outperformed in 23 (52% of the time). Of these 23 quarters, there were 21 periods in which small companies produced higher returns than large companies (the top right quadrant). Active managers outperformed in only two quarters (5% of occasions) when small companies did not produce higher returns than large companies.
It follows then, that the outperformance of smaller companies is a primary factor in whether active managers beat the market. Put another way, UK active manager performance is largely driven by an asset allocation decision: how much to hold in small versus large company stocks. But even despite the average overweight to smaller companies and their significant outperformance, less than 25% of stockpickers have beaten the broad UK market. In our opinion, this is largely driven by the charges levied by active managers.
The Nutmeg approach
Our approach is to not employ stockpickers, but to focus on the asset allocation decision – how much to hold in UK large and smaller companies. Many academic studies have shown that asset allocation is the primary driver of investment returns over the long term6. At Nutmeg, we achieve diversified asset allocation through picking the best-in-class exchange-traded funds, which cost from 0.07% to 0.10% per year for the best FTSE 100 (large and mid-companies) and FTSE 250 (small companies), rather than the average 0.94% charged by UK active equity funds6.
Keeping costs low and focusing on asset allocation, rather than stockpicking, is key to our approach – one that has delivered outperformance over the past five years compared to our competitors.
Risk warning:
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.
Sources
- https://eu.spindices.com/documents/spiva/spiva-europe-year-end-2017.pdf?
- As at end-February 2018. www.msci.com/documents/10199/2a6c82a5-0f0b-4a7c-93a0-d268027d3cd6. www.msci.com/documents/10199/99681988-f4d3-4c8b-9e9c-0db4f2998167. www.msci.com/documents/10199/facc2bc4-c6ed-46aa-9c1e-356fab513812. Source data: Macrobond using monthly MSCI UK net total return indices.
- Calculated as the annualised return of the period divided by the annualised volatility of month returns.
- Based on Morningstar definitions, mid, small and micro cap stocks account for 30% of the UK equity market whereas the average weight of active UK equity funds was 37% over 2007-2017 and 40% at the end of 2017.
- The top 10 companies accounted for 43% of the FTSE 100 as at 21/3/18.
- www.cfapubs.org/doi/pdf/10.2469/faj.v56.n1.2327
- Based on the UK All Companies active equity funds as at 31/12/2017, weighted by asset size, excluding tracker funds. Source: Morningstar. ETF cost data from Bloomberg.
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Shaun Port
Shaun is the chief investment officer at Nutmeg. He has over 25 years’ experience developing and implementing investment strategies for clients ranging from central banks to pension schemes to charities and private individuals. Shaun holds a degree in Mathematical Economics from the University of Birmingham and is a Chartered Alternative Investment Analyst. He can be found tweeting @ShaunPort.Other posts by Shaun Port