Value funds have proved the success story of the past three years in the UK all cos sector, which has provided a broad returns differential
Funds in the IMA UK All Companies sector have always displayed a broad differentiation of returns reflecting the sheer number of funds on offer, but intra-quartile performance reveals equally divergent returns.
In the first quartile alone, there is a 137.82% difference in performance between the top and bottom performers in the three years to the end of January 2002.
Solus Special Situations, top performer over the period, up 145.87%, has outperformed the bottom first quartile performer, Liontrust First Growth, ranked 60 out of 242, by 137.82%.
The difference in performance of the top and bottom funds in the second and third quartiles of the UK All Companies funds are much closer, varying between 7.78% and -0.77% for the former over three years, and between -0.78% and -7.6% for the latter.
The fourth quartile provides an even broader spread of returns with 45.14% difference in returns between the top and bottom funds in the quartile. Numbers range from -7.65% for Henderson UK Capital Growth down to -52.79% for the City Financial UK Performance fund.
Value funds, whether dubbed special situations or recovery funds, have been the top performers over the 12 months to the end of January, accounting for the majority of the seven out of 287 funds which posted positive growth over that period.
M&G Recovery, managed by Tom Dobell, is one such fund that has been able to outperform over the past two years as market conditions tilted in favour of the fund's mandate.
Targeting distressed and generally undervalued stocks, Dobell said the fund struggled throughout the 1990s against a backdrop of economic buoyancy, which limited the openings available to him. Between February 1999 and January 2000, M&G Recovery underperformed, up 14.52% versus a 20.21% average.
Dobell said: 'The fund broadly missed out on the technology boom because it was against the fund's objective to invest in companies with no profitability and the fund suffered as a result.'
The past two years have seen the fund outperform, however, up 11.95% between February 2000 through January 2001, compared to a sector average of 4.47% and down 14.35% over the 12 months to the end of January, versus a -16.55% average.
Dobell said the adverse economic environment and increasing short-termism in the market have afforded a greater number of opportunities of late, while a number of previously flat-performing, large holdings took off at the same time. He has also slightly upped his weightings in FTSE 100 stocks as more attractive valuations appear in that arena.
He said: 'There have been more opportunities in the FTSE 100 since the market has struggled and I would rather invest in these because they are more liquid and easier to exit when the time is right.'
The fund remains overweight small and mid caps though, with those asset classes comprising some 40% of the fund. Dobell invests on a three- to five-year view and will therefore ease into and out of holdings.
Dobell also has 5% of the fund invested in overseas stocks, including de Beers and Irish stocks, IWP and Grafton Group, which have bolstered performance and added further diversity to the 96 stock fund.
Reflecting the sector's fall from grace, Dobell is now able to buy into technology stocks on more attractive valuations. Dobell holds such firms as Systems Union and Filtronic, which he said are treated as any other stock, now the bulk of unprofitable and non-viable technology stories have gone to the wall.
Looking forward, the fund is zero weight pharmaceuticals and half weight banks, as Dobell sees little further upside in those stocks. Instead, Dobell said he is taking a number of meaningful positions in oversold stocks such as Rolls-Royce, which has slumped due to concerns about its profitability, but to an extent that overlooks the strength of its brand. He is also looking at high dividend paying companies on a stock specific basis.
Dobell added: 'In the long-term, a lot of market returns will come from dividends and if you can invest at the right time when the stock is cheap and paying a high yield, it can be very rewarding.'
Britannic UK General, on the other hand, is typically run with a growth bias, investing in the top 350 companies by market cap. Dave Clarke is the named manager, although the fund is very much run as a team process, with individual sector analysts putting forth their best stock ideas to Clarke, who has ultimate responsibility for stock selection.
When selecting stocks, the investment team targets quality companies with enticing earnings growth potential on attractive valuations. While favouring growth stocks over the long-term, the group is not shackled to that philosophy, according to Ralph Brook-Fox, UK fund manager at Britannic.
Allied to that, the fund is run as a diversified portfolio, comprising between 60-80 stocks, with large and mid-cap exposure determined by bottom- up stock selection rather than any macro outlook. The fund has a slight bias to large caps, in the flight to quality and this is reflected in the fund's beta score of 0.92, compared with the sector average of 1.0.
The fund underperformed over the three years to the end of January, posting growth of -8.73%, compared to a sector average of 4.24%, but analysis of discrete period performance reveals both periods of outperformance and underperformance over that timeframe.
From the beginning of February 2000 through January 2001, the fund underperformed, falling by -1.53% compared to a sector average gain of 4.47%.
Brook-Fox said this was largely due to prolonged exposure to the poorly performing technology and telecoms sectors.
He explained: 'The main reason for the underperforming in 2000 is because of the growth bias, although stocks in general had a bad time. We realised the error of our ways and moved underweight technology and telecoms later in the year, but the benefit of that did not really show until the next year.'
Over the 12 months to the end of January, the fund outperformed on the back of underweighting high beta sectors of the market. Britannic UK General was able to post growth of -15.47% compared to a sector average of -16.55%.
Brook-Fox noted: 'Last year was the year we benefited from being underweight technology. It is a growth area, but there are certain times in the cycle when we won't invest in growth for growth's sake. We were underweight IT hardware, so we avoided the likes of Marconi and underweight software and media, which had a torrid time.'
Looking forward, Brook-Fox is overweight banks and pharmaceuticals, but has started to lighten these positions in favour of a tentative push back into technology, in anticipation of economic recovery and an increase in corporate spending.
Brook-Fox said: 'Valuations no longer look so stretched in technology and technology spending is going to start improving as IT budgets build up again. We are selectively putting a toe back in the water, with both IT hardware companies such as Spirent and software companies, like Sage and Misys.
He remains downbeat about the media sector though, as advertising, spends remain depressed and is wary of mature industrials which may struggle to grow earnings.
Regression analysis: Regression statistics can be used to compare the relationships between funds, markets or a specific benchmark index. They do not make the assumption that the variables (funds) are related as cause and effect, but permit them to be influenced by other variables (markets).
Alpha: The Alpha describes the theoretical reward obtained by one investment when the second investment has a zero return. To calculate the Alpha, the returns of each are taken and compared together to identify their relationship. This reveals relationships between investments in both bull and bear markets. When applied to portfolios, it can be considered to be the return over and above (or below) the market through portfolio strategy. Good managers have a positive Alpha.
Beta: The Beta is the amount the first fund moves when the other moves by one unit. Beta is a measure of relative volatility (absolute volatility is calculated by standard deviation).
If one fund always goes up and down by 1.5 times of the performance of the index, its Beta will be 1.5. This implies that if the return of the index is positive, then 1.5 times this positive return can be expected of the fund. If the index goes up (or down) 10%, the fund goes up (or down) 15%. Beta represents the volatility of the first investment versus the second. It is only an estimate and to be accurate there has to be a perfect correlation between the two investments.
Correlation: Correlation shows the strength of a linear relationship between two funds. A perfect correlation is when the investments behave in exactly the same manner. A perfect positive correlation is represented by 1, perfect negative correlation by -1 and no correlation with a 0. A perfect negative correlation suggests that for every 1% movement by the index we would expect to see -1% movement return on the fund and vice versa. This is an important factor when using modern portfolio theory.
Source: Standard & Poor's
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