The next best thing to a crystal ball

Markets are too complex to predict but looking beyond performance and planning for multiple scenarios can help in building a portfolio that can benefit from unforeseen events

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It seems more investors are finally starting to notice how well many UK companies and funds have been doing in recent years, while the hype was ushering them into the supposedly younger, debt-free emerging market growth economies.

The UK All Companies sector has been bottom of the IMA sales chart for eight out of the past 12 months, despite the fact that many of its funds have produced exceptional returns.

In fact, the best-performing fund in the sector – Neptune Mid Cap – has made 97.34 per cent over the past three years as the best emerging market fund – First State Global Emerging Markets Sustainability – has made 38.47 per cent.

Many UK funds have produced outstanding returns while the emerging markets, which have received greater press, have stagnated. In fact, the average return of a top-quartile UK fund over that time – there are 67 of them – is 68.98 per cent.

One of the lessons we should learn from this is that markets are not economies: so much of financial journalism focuses on economics that this can sometimes get lost.

Quarterly GDP growth in this country has averaged 0.04 per cent since January 2009, while the FTSE All Share has averaged returns of 3.29 per cent a quarter. UK unemployment has been running at an average of 7.88 per cent, but the FTSE All Share has made 85.11 per cent.

What this really teaches us is that you need to take diversification seriously. If you had steered clear of the UK market out of fear of the underperforming economy you would have missed out on some fantastic returns.

It is understandable why people have shunned the market: there has been so much doom and gloom around the economy, joblessness and the UK’s future compared with Asia that having a weighting in your portfolio must have seemed useless. I’m sure if we were to go back a few years we would see the papers full of articles explaining how to invest in Asia to escape the economic disaster at home.

However, UK funds have made investors more money, which highlights the importance of a truly diversified portfolio: markets are complex, and no-one is capable of consistently, reliably predicting their course.

So how have UK funds managed to buck the predictions? Using a regression analysis to uncover how the top-performing UK funds have made their returns uncovers some interesting results.

Regression analysis consists in breaking down how a fund manager generates returns by finding which combination of benchmarks best predicts his fund’s returns.

The historical relationship between the fund’s returns and the various benchmarks are measured, and the software constructs a model weighted to the relevant benchmarks that most closely fits the fund’s performance.

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The analysis gives us a number – r squared – which tells us how much of the fund’s returns can be explained by the model, and a tracking error which represents how much value the manager’s stockpicking is responsible for over and above this.

If we look at Cazenove UK Opportunities, for example, a well-known fund that appears on our FE Select 100 list, we can see that manager Julie Dean’s returns have come from heavily overweighting the FTSE 250.

Dean’s fund is run with the input of a business cycle team of analysts whose job it is to judge where the economy is in the cycle and decide where the fund should be best positioned to take advantage. The team is able to pick their sector bias at will, changing their industry biases or market cap biases as they think appropriate.

Being 55 per cent invested in that mid cap index, 34 per cent in the FTSE 100 and 11 per cent in the FTSE Small Cap explains 85 per cent of her returns, with a mixture of good stockpicking and luck responsible for the remaining 15 per cent.

Those figures are strikingly similar to those of Neptune UK Mid Cap, whose analysis tells us that a model of 24 per cent in the FTSE 100, 54 per cent in the FTSE 250 and 22 per cent in the FTSE Small Cap index explains 80 per cent of its returns.

Clearly the team behind the unconstrained Cazenove fund has made a good call in being in the mid cap sector of the market.

The excess tracking error tells how much the fund’s price has digressed from the returns of the model. Cazenove UK Opportunities has a tracking error of 0.74 to its model, and Neptune UK Mid Cap 0.96, suggesting both funds follow their models reasonably closely.

Managers that invest heavily in the mid cap area of the market have done particularly well over the past few years. Many, like Mark Martin’s Neptune UK Mid Cap, advertise the fact in their name. Some, like Dean’s, do not, however, which is a potential problem for investors.

The last thing you want is a group of funds that are all drawing their returns from the same markets: this is the opposite of diversification, and will only end in you blending your returns back to the mean. It is noticeable that many of the top-performing funds have been moving into this sector, which is something investors should keep an eye on. It is expensive to run two cars when you only need one.

Standard Life UK Equity Unconstrained is another fund to have been fishing in the FTSE 250. Analysis of this fund, however, shows that it has been less benchmark-aware than the other two funds under discussion. The fund has a high tracking error of 5.4 per cent to the best benchmark regression analysis can provide, suggesting the manager is taking more aggressive stock-specific bets.

There could be more of a case for holding this fund together with one of the Cazenove and Neptune funds, assuming that how the manager picks stocks is consistent, but the diversification benefits of are not going to be high.

The last thing investors want is funds all drawing their returns from the same markets

A lot of smaller companies funds have been moving into the mid-cap space as well, which is something investors need to be alert to, as it may surprise them.

Henderson UK Smaller Companies, for example, has become highly dependent on the FTSE 250. Regression analysis shows a model 84 per cent weighted to the FSTE 250 and 16 per cent to the FTSE Small Cap index explains 89 per cent of its returns, with the tracking error being just 0.84 per cent.

It has to be said, that the Henderson fund takes the Numis Smaller Companies index as its benchmark, and that index overlaps with the FTSE 250. In other words, it is not as surprising as it might seem at first glance that a smaller companies fund has such a high dependency on the FTSE 250.

However, this dependency needs to be taken into consideration. If you are building a portfolio then you want to make sure each fund is offering something different, and you are not covering the same ground in your UK smaller companies fund as in your large cap portfolio.

Within the IMA UK All Companies sector there are some funds that have been fishing in different pools and still had success. Nigel Thomas’ Axa Framlington UK Select Opportunities has managed to eke out top quartile returns despite investing in the less popular large cap sector.

Regression analysis shows that a model weighted 70 per cent to the FTSE 100 and 27 per cent to the FTSE 250, with 3 per cent in the FTSE Small Cap, explains 88 per cent of his returns, with a low excess tracking error of 0.59 per cent. A lower tracking error is to be expected with a fund focused on large caps, however, where the potential for outperforming through stockpicking is lower.

Artemis Income is another good way to get large cap exposure into your portfolio, although the fund sits in the IMA UK Equity Income sector. A model weighted 78 per cent to the FTSE 100 and 22 per cent to the FTSE Small Cap index explains 81 per cent of its returns, with an excess tracking error of 0.81 per cent.

It is important to look for this sort of diversification. While the mid cap sector has had a good run over the past few years, it is unlikely to continue for ever.

We have seen sustained periods of outperformance for the FTSE 100 before, such as the 1990s. Between 1 January 1990 and 31 December 1999 the FTSE 100 made 328.62 per cent as the FTSE 250 index made just 258.35 per cent. The FTSE Small Cap put on just 177.94 per cent.

At least one of the features of that time looks like it is being repeated today – namely dollar strength and emerging market weakness.

The FTSE 100 also held up much better in the difficult year of 2007, returning 7.36 per cent as the mid cap index lost 2.46 per cent and the small caps did even worse.

We started to see what looked like a similar environment in the first few months of the year. In the three months from 22 February to 22 May, when the markets peaked, the FTSE 100 was running almost neck and neck with the FTSE 250, returning 9.32 per cent against the mid cap index’ 9.56 per cent.

The point is that you can never be sure what is around the corner, and a portfolio massively tilted towards the mid caps will miss out on what the large caps have to offer, both in terms of better downside protection but also the potential to outperform in certain circumstances.

It will be interesting to see what happens if we ever see what looks like a sustained, strong period of recovery in this country: will the mid caps continue to build on their success or will the FTSE 100 stocks be freed from a weight of worry over the economy and rebound faster? It would be foolish to pretend you can be sure.

To prudently construct a portfolio we need to look beyond performance to find why a fund is doing well and in what sort of situations it is likely to do well in the future. Planning for multiple scenarios is how you avoid the need to be able to see into the future and build a robust portfolio capable of benefitting from unforeseen events.