The general trend for managers has been to stay away from TMT and small caps and move towards large-cap, defensive stocks
UK equity funds are still recovering from the battering they have received over the past three years.
Some managers are fighting a rearguard action, trying to suit their investment processes to the new environment, while others have attempted a wholesale change. Either way, the general trend has been away from TMT and small cap and towards large-cap, defensive stocks.
Rae Brooks, manager of the CrÃ©dit Agricole UK fund, took over the fund in 2002 after a period of underperformance brought about by the tech fall.
Over the last three years the fund has been in the bottom 10 in the asset class, but has seen a continually improving position and for the 12 months to the beginning of March had a percentile ranking of 51, about half way down the league table.
From 1998 to 2000 the fund performed well, according to Brooks, but that performance turned down in 2001 to 2002.
The manager moved from Paris to Milan and a new manager took over the fund during this period, which may have hurt performance. The fund also suffered through realignment to a market neutral position, he says.
In 2002 the fund's management was moved to London under Brooks with the aim of retrieving the situation. The fund had around 90 stocks in it at that time.
Brooks reduced that number to 60 in the first week and reduced TMT weightings further still.
He also applied an investment process to take the fund away from total reliance on stock picking.
'Fund managers can fall in love with a position and hope for a bounce even if it does badly,' he explains.
Stock selection is now a mainly top-down exercise. Brooks looks at positions in terms of making the portfolio reflect his view of the global market first. Then he looks at the portfolio to make it consistent with his sector views. Finally he relies on stock picking within those boundaries.
The fund's tracking error has also been brought down from 8% to 2% to stabilise performance.
'You can only have a high tracking error if you are very confident of market direction,' says Brooks.
'Trends are difficult to spot at the moment. We have reduced the tracking error and are taking small bets of which we are quite certain.'
Since taking control Brooks has changed his position on telecommunications to some extent, moving from a three-year bearish stance on Vodafone to an overweight position in the last four months.
The fund is also overweight food manufacturers and tobacco companies as a means of replacing the risk in earnings of the TMT sector with visibility and certainty of earnings.
Looking ahead, investors will seek out certainty of income due to the way markets have behaved, according to Brooks.
'The risk of owning equities is now being realised by investors,' he says.
Today's market environment is a long way from that of three years ago, according to David Stevenson, an investment manager at Scottish Value Management. The SVM UK Growth fund has moved from a small and mid-cap bias to a larger stock bias to reflect that.
This fund has also seen improving performance relative to its peers over the last three years and is now ranked about middle in the asset class with a percentile ranking of 55.
In 2000 small- and mid- cap stocks outperformed large-cap and the fund outperformed as a result, according to Stevenson.
At the start of that year the fund was exposed to the TMT sectors as well as outsourcing and support services, because those industries showed good prospects for sustainable growth, he said.
Towards the end of 2000 there were the first signs of a market slowdown, especially in the IT sector, and this affected the fund's performance.
The slowdown had a larger affect on small- and mid-cap companies and the fund managers began to address the problem by reducing exposure to those stocks.
'We took the view that if we were going to see a turning point in interest rates this was going to be it and it appeared early in 2001,' he says.
'We thought the most affected would be the consumer in the high street and upped exposure there.'
2001 saw mid caps outperforming and small caps under-performing and the fund's new focus on larger-cap stocks saw improvements in performance. The fund also benefited through several stock promotions out of mid cap into the FTSE.
Interest rate cuts helped to drive consumer activity but storm clouds continued to gather for IT ' in early 2001 the fund had removed exposure to that sector almost entirely, which meant further reductions in small and mid-cap exposure.
The key theme in the fund became retail, support services, financials, healthcare and pharmaceuticals.
'We suffered in the early part of the year because we were realigning from TMT,' says Stevenson.
'We outperformed in the remainder of the year, but the impact of the first few months left the fund behind in performance.' By the end of April he was realigned out of the TMT bubble.
The main drivers to performance were retail and promotions from mid-cap to large- cap indexes.
These promotions, as well as a general shift that way, led to an increased large-cap element in the fund in 2002.
'Mid- and small-caps under-performed in 2002 and we anticipated this,' says Stevenson.
Now two-thirds of the portfolio is in large-cap stocks and will remain there for some time, according to Stevenson.
'Exposure now is limited to consumer staples in small- and mid-cap stocks ' food retailers and pubs,' he says.
One of the most important factors in stock selection now is cash generation, which enables firms to pay down debt, boost dividends and buy back shares.
In small- and mid-caps the fund still holds food, drink and gaming stocks, which Stevenson believes are robust enough to survive the harshest market environment.
It also has exposure to mining stocks in order to exploit the underlying appreciation in precious metals and oil prices. This is a good way of playing cyclical industry exposure, said Stevenson.
In the mid-cap arena the fund is exposed to house builders, where there is still good visibility, he added.
In large-cap the fund holds oil companies and financials. Its financials weighting is stock-specific, avoiding any life insurance exposure.
The fund is likely to remain defensive, making calls on cash flow generation rather than on sectors.
The CLI Fidelity Special Situations fund, which has been one of the best performers in the asset class over the last three years, has been overweight mid- and small-cap stocks.
The fund invests a minimum of 80% in UK equities and in a small part overseas. It is a stock-picking fund with no benchmark restrictions.
Its small- and mid-cap bias is because there are more valuation anomalies in these areas, but their higher volatility can also affect the fund, according to Julia Edwards, senior analyst for Fidelity Special Situations fund.
Nevertheless, the fund has shown relatively steady performance over the last three years and has remained in the top 10% of funds in terms of performance. The fund is now overweight in non-life insurance companies and food and drug retailers.
It has taken long-term underweight positions in banks, pharmaceuticals and oil companies because there are less mid- and small-cap opportunities and they are better researched providing fewer valuation anomalies.
Fidelity remains an ardentvalue investor and stockpicker, and that has not changed over three years, says Edwards. Its five criteria for taking a position are turnaround or recovery situations, overlooked growth prospects, selling below asset valuation, anomalies in valuation compared to other similar companies around the world and corporate potential such as takeovers.
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