A bias towards mid-caps over small and large caps – as much as stock selection - is the reason so many active funds have underperformed the FTSE All Share so far this year after many years of good performance, according to Insight’s Tim Rees (pictured). 
The manager, who heads up the £200m Insight Equity Income fund, points out that buying and holding medium-sized companies magnifies the rises and falls in a portfolio and, given the strength of blue-chips this year, this has meant many funds have struggled to beat their benchmarks.
What’s more, he argues many intermediaries will put investors into the top-performing funds at their time of purchase, which has led to further disappointment year-to-date given the swift reversal in the market’s performance.
“There is a dreadful habit in this industry that has been around ever since I joined,” he said.
“Advisers tend to advise on the top-performing funds and, if ever you want to get into a situation where you do the reverse of what you’re meant to do - ideally you buy low and sell high -then getting the best-performing fund risks doing the opposite then becoming disillusioned, disappointed and selling low.”
Rees says this investor behaviour is demonstrated in a study by financial journalist Gary Belsky and psychology professor Thomas Gilovich who, in their book ‘Why Smart People Make Big Money Mistakes’, argued that investors were achieving half the performance of both the average US fund and the S&P 500 index because they were chasing the best-performing vehicles.
Because of this behaviour, he reasons that many investors have bought into funds with a heavy mid-cap bias over recent years and, given the recent surge in large-caps, have been left disappointed when managers have struggled to outperform their FTSE All Share benchmark year-to-date.
Data from FE Analytics shows that the IA UK All Companies, IA UK Equity Income and IA UK Smaller Companies sectors have all underperformed the FTSE All Share on average so far this year. The smaller companies sector has been worst-hit, achieving less than half the total return of the FTSE All Share at 5.42 per cent.
Performance of sectors vs index in 2016
Source: FE Analytics
Over five years to the end of 2015, however, the IA UK Smaller Companies sector more than doubled the performance of the FTSE All Share with an average return of 72.83 per cent. The IA UK All Companies and IA UK Equity Income sectors outperformed the index’s 33.82 per cent return by 8.64 and 18.02 percentage points respectively over the same time frame.
Rees has always maintained a large-cap bias cross his portfolios as a means of reducing volatility and in his other fund, the Insight Equity Income Booster fund, this large-cap bias allows for the application of an option overlay, which is the mechanic used to achieve that fund’s higher yield. While this means he can struggle when domestic-facing companies are outperforming, he says it creates stability and consistent returns for his clients rather than offering significant bursts of outperformance and underperformance.
“If you plot the [IA UK Equity Income] sector performance against the All Share over 30 years, you will find that the way the sector has varied against the benchmark is staggering,” he pointed out.
“You have periods of massive outperformance and massive underperformance. The underperformances were obviously the tech bubble and the financial crisis and so forth, then you have massive default outperformance.”
“These peaks and troughs are basically plus 10 per cent or minus 10 per cent of the FTSE All Share, so it’s substantial. What we wanted to do was to simply say that it’s not what people want when they buy into equity income funds generally.”
The manager says many investors attempt to generate income through UK equity income funds can often end up with portfolios above their risk threshold.
To gain 1 percentage point more yield than the FTSE All Share, for instance, investors will run the risk of underperforming the index by 10 percentage points if they buy into a fund tilted toward its riskier areas.
He also says investors can mistakenly believe that a fund’s strong outperformance is only due to careful stock-picking when, actually, it might simply be because they have had a bias towards higher-risk and cyclical mid-caps.
“The [FTSE] 250 has massively outperformed primarily because of a re-rating, not necessarily because the companies have produced better earnings. You’ve gone from a sector that had a yield premium to the All Share to one where it has a yield discount – that’s just the outperformance explained in fairly short order,” he continued.
“When you look at the other equity income funds, a lot of them are heavily biased towards FTSE 250 and small-cap stocks. A lot of the funds call themselves ‘multi-cap’ which is a nice way of trying to make a small-cap fund sound as if somehow it has the potential to be in large-cap when in reality, it’s a small-cap fund.
“They know the problems they have to face – sometimes they’re looking good and other times they’re clearly not flavour of the month. They call themselves multi-cap because somehow you think they might be able to invest elsewhere in the market.”
As such, Rees says investors need to look at the weighting a fund holds in small-and mid-caps to determine the cause of its performance and adjust its returns accordingly.
According to data from FE Analytics, every fund across the IA All Companies and UK Equity Income sectors that made more than 100 per cent over the last five years to the end of 2015 are all heavily-biased towards mid and small-caps.
Year-to-date though, all but one of these funds are in the third or fourth quartile for their returns.
Top-performing UK equity funds over 5yrs to 2015
| Fund name | Total return (%) |
| Neptune UK Mid Cap | 138.92 |
| Old Mutual UK Dynamic Equity | 125.8 |
| Old Mutual Equity 1 | 122.91 |
| Old Mutual UK Mid Cap | 121.1 |
| Barclays UK Lower Cap | 111.39 |
| MFM Slater Growth | 104.47 |
| EdenTree UK Equity Growth | 101.22 |
Source: FE Analytics
“The reality is they were not all geniuses in 2010 to 2015 and they’re not villains now, it’s just where they’ve invested and over the years they have clearly done very well. They got far more praise than they probably deserved over the past five years and they’re now being held up by people asking why it’s all gone wrong – it’s because the FTSE 250 hasn’t done quite as well,” Rees said.
“The irony is the FTSE 250 has actually done very well over the last few days to the point where markets are going up when sterling’s been weak, when normally you would associate this with the outperformance of the FTSE 100 rather than the FTSE 250. So we shall see.”
“What was surprising is how prolonged the outperformance of the FTSE 250 has been. It’s still a really interesting debate going forwards.”
Over Rees’ 12-year tenure, Insight Equity Income has returned 178.56 per cent, outperforming its sector average and benchmark by 6.7 and 6.04 percentage points respectively.
Performance of fund vs sector and benchmark under Rees
Source: FE Analytics
The fund has a clean ongoing charges figure of 0.82 per cent and yields 3.88 per cent.