Behind the Numbers: Why did so many managers fall into a Brexit mid-cap trap?

Until 24 June last year, the FTSE 250 had consistently outperformed the FTSE 100 for three years, reflective of both the sustained recovery of the UK domestic economy and the resource-heavy blue-chip index being hit by falling commodity prices. In response, fund managers invested more heavily in mid caps.

However, Britain’s decision to leave the European Union saw a complete reversal of this trend, with UK mid caps bearing the brunt of the selling and the FTSE 250 underperforming the FTSE 100. So why did so many managers fall into a mid-cap trap and are mid caps behaving in line with expectations now?

The numbers
4%
Underperformance of the FTSE 250 versus the FTSE 100 in the immediate aftermath of the UK’s vote to leave the EU

82.5%
Dispersion between top and bottom 50 performers in the FTSE 250 in the lead-up to Brexit compared with 40 per cent in the FTSE 100

3.92
Tracking error between the IA UK All Companies and the FTSE 250 in the lead-up to Brexit versus a long-term average of 6.21

0.82
R-squared ratio of the IA UK All Companies sector relative to the FTSE 100 index at the end of June 2016 compared with a long-term average of 0.94

Pre-Brexit mid caps: better and safer?
In the five years leading up to the British public’s vote to leave the EU, UK equity active fund managers invested heavily in the mid caps market.

And it is clear to see why. Significantly allocating to FTSE 250 index members would give them a more direct exposure to the domestic and the British consumer market which was more reliable than the overseas markets.

The allure of mid caps was also intensified by the fact that alongside small caps, they benefited most from the trend of decreasing volatility of UK equity markets since the start of the financial crisis.

For example, during the fourth quarter of 2015, the rolling three years’ volatility for the FTSE 250, FTSE Small Cap and FTSE AIM All Share all stood below the volatility of the FTSE 100 for the first time since 1997.

The fact that the FTSE 100 is heavily weighted towards the oil, gas and basic resources sectors best explains this anomaly, in a period where commodity prices fell sharply.

Volatility is not the only measure to highlight that trend. We can also look at the beta relative to the FTSE All Share index. Betas for the FTSE 250, FTSE Small Cap and FTSE AIM All Share at the time of the EU referendum were significantly below their long-term average.

The evolution of the tracking error data pre-Brexit between the IA UK All Companies and the FTSE 250 shows that the average UK equity manager did not miss the opportunity to invest in the safer mid cap area. Tracking error at the end of June 2016 stood at 3.92 which is significantly lower than the long-term average of 6.21.

During this period, the average active manager also shied away from the then riskier FTSE 100.

The R-squared ratio – which indicates how closely correlated a fund is to an index or a benchmark – of the IA UK All Companies sector relative to the FTSE 100 index at the end of June 2016 stood as 0.82 – once again significantly lower than the long-term average of 0.94.

The tilt towards mid caps best explains the outperformance of the IA UK All Companies sector relative to the FTSE All Share in 2015, as an average UK All Companies managers generated a return of 4.9 per cent while their benchmark returned 0.8 per cent.

Stockpicking opportunities
To justify their market-cap allocation pre-Brexit, active managers also claimed that the UK mid caps market offered a higher opportunity to add value through stockpicking. Market opportunity can be measured by the dispersion of stock returns within an index. Here we use the FTSE 100 as proxy for large caps and the FTSE 250 for mid caps. The comparison indicates that this was the case, at least for the five years running up to Brexit, as the dispersion in returns for the FTSE 250 is higher.

In the five years running up to the Brexit vote, on average the top 50 performers of the FTSE 100 index have outperformed their benchmark by 38.8 per cent; conversely the bottom 50 stocks have lagged by -1.2 per cent. In other words, the dispersion between the top and bottom 50 stands at around 40 per cent over the last five years. These numbers significantly increase for the FTSE 250 index with the dispersion in relative returns between the top and the bottom 50 being twice as big at 82.5 per cent.

It is also interesting to see that this dispersion number was skewed to the upside for the FTSE 250 index, contrary to the FTSE 100 index in the same period. On average, the top 50 stocks in the FTSE 250 index have outperformed the benchmark by 66.25 per cent over recent years. Conversely, the bottom 50 performers have underperformed by -16.2 per cent. Therefore, a UK equity active fund manager would have made the right decision to put more money into the mid caps index as its relative downside was limited while its relative upside was much higher.

Ignoring the political risk of mid caps
So, active UK equity managers made hay while the sun shone in the mid- and small-cap markets in recent years, but few were prepared for the outcome of the EU referendum. Britain’s decision to leave the EU shocked global investors, triggering a bout of turmoil in markets which hit the FTSE 250 – the London stock index most closely tied to the UK consumer – the hardest.

In the immediate aftermath of the referendum result, the FTSE 250 underperformed the FTSE 100 by 4 per cent on the aptly-named ‘Black Friday’. While the subsequent rebound was impressive and many managers – eager not to crystallise their loss – held their mid cap positions, the fundamentals no longer support such high allocations.

Suddenly mid caps no longer represented a less risky option. If you were invested in the FTSE 250 for three months around the EU referendum vote, you would have lost more than if you were invested in the FTSE 100.

Furthermore, there has been a reversal in the trend of betas for the FTSE 250, FTSE Small Cap and FTSE AIM All Share relative to the FTSE All Share, which are now back in line with their long-term averages.

Brexit, and more recently the election of Donald Trump to US president has caught many active managers off guard. These events have proven that even when outcomes seem a dead cert, often they are not. Managers did well from allocating more heavily to mid caps pre-Brexit.

However, they should have been better prepared for unexpected outcomes and isolated the political risk in their portfolios. Given the further significant elections on the horizon and a wave of populism sweeping across the West, 2017 could be just as dramatic, and that’s before we have even worked out what Brexit and a Trump presidency mean. In light of all this, active managers must prepare their portfolios for the unexpected to avoid being caught out again.