With lower UK equity returns predicted in 2021, finding alpha will be more important for investors. But where should they look for it? David Hambidge, Investment Director, Multi Manager funds, Premier Miton Investors takes a view
When investors study their latest portfolio valuations, they should (I hope!) be satisfied with the results. Certainly any equity biased or more balanced portfolio should have achieved a decent gain over the first five months of the year with strong returns from global stock markets more than offsetting weakness in government and investment grade corporate bonds.
At the start of the year we highlighted that UK equities represented good value due to the fact that the FTSE All-Share Index was a clear laggard in 2020, Brexit had been dealt with (sort of) and that many domestic and international investors had shied away from the UK stock market since the 2016 referendum. We are not surprised therefore that the FTSE All-Share Index has outperformed all other major stock markets in sterling terms this year, gaining 10.9% to the end of May compared with a rise of 6.7% for the FTSE All-World Index (£).
The UK economy suffered more than most in 2020 as a result of the pandemic and this clearly had a negative impact on share prices. However, this year, GDP is forecast to rebound strongly as a result of the successful vaccine roll out. This is attracting investors to all areas of the UK stock market and in particular smaller companies, with the FTSE Small-Cap Index up over 27% driven in part by a surge in M&A activity
The outperformance of mid and small-cap stocks, both in the UK and overseas, is helping many active fund managers produce better returns than the broader index. Again, this is particularly true in the UK where not only has the IA UK All companies sector produced superior returns than the FTSE All-Share Index so far this year but also over the medium and longer term.
There has been much debate over the years as to whether active or passive investing is best. In my view, both have merit but the fact remains that if you would like to have a decent exposure to UK smaller companies, you won’t get that through a tracker fund. In addition, if you, like me, believe that investment returns (including from equities) are likely to be significantly lower going forward, then Alpha is going to become very valuable and this is more likely to be achieved in a small-cap fund than one investing in large and mega-cap stocks.
Away from the UK, stock market returns have also been linked to the success (or otherwise) of the vaccine rollout. As a result, US share prices have been well supported, while European equities have recently started to catch up. However, in Asia and Emerging Markets, equity returns have lagged with many economies struggling to open up.
With the exception of high yield it has been a tough year for bond investors and particularly those in longer dated developed market government debt. Strong economic growth and rising inflation are bad for bonds at the best of times, but with yields still very low by historic standards, the likelihood of huge swathes of the bond market providing a return in excess of inflation is very slim indeed.
Unfortunately there is little room for complacency in the high yield space either. This is simply because as elsewhere, yields are no longer high and this lack of yield support leaves the sector vulnerable to even a modest pick up in defaults with the problem likely to be compounded by lower than normal recovery rates.
On a cheerier note, there are still assets that offer reasonable value assuming that we remain in a relatively low interest rate environment, but investors will have to be more selective going forward. One change we have recently made to our income producing funds is to reduce our exposure to corporate bonds and increase our weighting in specialist areas of the UK commercial property market, including primary healthcare facilities. These assets offer very robust dividends which should grow year on year and are likely to perform much better than longer dated bonds and especially if the recent rise in inflation turns out to be more than transitory.