Are investors falling back in love with the UK? I suspect this would be taking it too far, but we have at least had some positive signs from the currency markets. Sterling made its way up to $1.40 for the first time in nearly three years on 19 February – a long way from its March 2020 doldrums of $1.15.
Explaining any market moves often involves conjecture, but this recovery does illustrate the positive narrative emerging behind domestic stocks. After a difficult 2020, the UK looks likely to shake off the shackles of the pandemic more quickly than many other nations thanks to its rapid vaccine roll-out.
The absence of perpetual Brexit negotiations might also help matters. As Janus Henderson portfolio manager Oliver Blackbourn put it: “With the immediate trading relationship with the EU now known, investors can get back to looking at fundamentals.”
But can they get back to buying UK equity funds? Investors have ditched open-ended funds with a UK focus to the tune of billions of pounds in each of the past five full calendar years, Investment Association (IA) data shows. This makes sense given Brexit uncertainties, market returns that have lagged those available overseas and a pandemic that has challenged the UK’s valuable dividend credentials. But with domestic shares looking both cheap and better positioned, investors may wish to jump back in.
Very recent data suggests that this has not happened just yet, at least when it comes to what I will call ‘generalist’ funds for now. Investors yanked a net £2.3bn from UK equity funds in January according to Morningstar, a figure that is highly discouraging even if money was also taken from equity funds across the board that month. Of the active UK equity funds that suffered withdrawals, Morningstar notes that Majedie UK Equity (GB0032730698) and Royal London UK Equity Income (GB00BJ9MHJ70) were among the hardest hit. The manager of the latter, Martin Cholwill, is due to retire later this year – although the announcement of his retirement was made after January, and does not explain the withdrawals.
IA data shows that investors also continued to ditch UK funds in late 2020, even as vaccine news led the FTSE upward. And yet a mini resurgence is quietly taking place in the small-cap space. UK smaller company funds bucked the multi-cap (or ‘generalist’) trend, attracting inflows in January. This continues a development that ran through October, November and December.
Going down the market cap spectrum seems like a well-targeted way to capture any uplift: many smaller companies can offer exposure to a recovering domestic economy and some benefit from a rising sterling. As this week’s Fund Idea discusses, a small-cap approach also takes investors away from some of the UK’s problem sectors, to an extent.
On a related note, small-cap exposure is the form of UK allocation investors seem more likely to lack in portfolios: the IA’s UK All Companies sector, which holds multi-cap funds, was still the second most popular fund sector at the end of 2020 even after years of outflows, with some £155.6bn in total assets. The UK Smaller Companies funds, by contrast, held just £17bn.
But perhaps this also demonstrates a pattern it would be wise to continue, of investors using small-cap investments as riskier ‘satellite’ positions, or smaller weightings that serve to boost returns without threatening to capsize the portfolio in a bad year.
Small-caps are a great source of growth, especially if the economy comes roaring back. But positions should be sized accordingly and held in a well-diversified portfolio. Small is beautiful in all senses here.