By Danielle Levy of Citywire

The ‘free lunch’ is over for investors backing the UK mid and small cap momentum trade, according to Neptune Income manager Robin Geffen.

The average fund in the Investment Association’s UK Equity Income sector had close to 41% in mid and small caps in November 2016, according to data from Morningstar Direct. It was a trade that paid off between 2011 up to the middle of this year, powering the performance of many UK equity funds. Over the past five years, the FTSE 250 index has risen by an impressive 81.4%, more than twice the 30.7% return of the blue-chip FTSE 100.

Close to 90% of UK equity income fund managers performed better than the FTSE All-Share index in 2015, buoyed by their small and mid cap exposure. However, 2016 has seen a marked reversal – with only 9% performing better than the index year-to-date. The UK’s surprise vote in favour of leaving the European Union (EU) in late June hit more domestically focused small and mid caps. They have since recovered, but Geffen believes the good days are over for fund managers backing this trade.

In his opinion, only genuinely active stock pickers will prosper in today’s extraordinary investment environment, as the UK prepares to invoke Article 50 to start the process of leaving the EU, Europe grapples with a raft of oncoming votes and the world gets ready for Donald Trump as the next US president.

Small and mid-caps performed well during a period of low interest rates, low inflation, a stronger pound and higher consumer and business confidence. However, today higher interest rates and inflation appear to be on the horizon, the pound has weakened and there is political, social and economic uncertainty. In Geffen’s opinion, these factors represent headwinds for small and mid-caps.

The Neptune Income fund has a bias towards large and mega caps. Although sterling strength had represented a challenge for many UK multi-nationals, the recent depreciation in sterling has provided a boost. The fund’s large cap allocation has paid off more recently, enabling the fund to feature in the 9% that beat the index so far this year.

Over the past 12 months, the Neptune Income fund is up 9.5% compared to 4.5% by the average fund in the Investment Association’s UK Equity Income sector. Over three years, the fund has returned 16.4%, while the sector average was 17.3%. The fund has a net yield of 4.1%.

‘We have a FTSE 100 that derives around 70% of its earnings from overseas. As a fund manager who has been running a UK equity income fund through the last five years and before that, this has been quite an unpleasant headwind to negotiate. We have even seen [sterling] overvalued against the euro, but the game has changed. It has changed big time,’ said Geffen, who is the founder of Neptune Investment Management.

‘Over the last year, only seven UK equity income funds have outperformed the All Share. There is nothing one-off about this. This is going to be a feature going forward.’

Bond proxies will struggle

Geffen’s enthusiasm for large caps does not extend to the so-called ‘bond proxies’, which are stocks that offer bond-like stable dividends. These companies are typically described as ‘quality’ stocks because of their strong track records – even during tough times.

Although they have performed well in recent years, Geffen says that investors should not expect the same gains looking ahead. Since August, bond proxies have fallen out of favour as a result of a market rotation into cheaper stocks with greater economic sensitivity. Geffen suggests that this is a sign of things to come.

‘The last five or six years are an anomaly. Quality growth is trading at a 45% premium to the wider market. This is another free lunch that is over, dead, buried. Some of these share prices have soared in spite of earnings downgrades and very limited sales growth,’ Geffen said.

The fund manager cites Reckitt Benckiser, which owns household cleaning brands like Vanish and Dettol, as a prime example. He decided to sell out of the stock earlier this year because its dividend was not growing in line with its share price.

Income managers face the added challenge of finding companies with higher dividend yields than the market. Less than 30% of stocks currently yield more than the market, which means that income investors are potentially fishing in a small pond.

So where do the opportunities lie?

Geffen likes US banks and UK life insurers and increased exposure to mining and energy stocks after commodity prices stabilised.

The fund manager has a bias towards large and mega caps which derive a large portion of their earnings overseas, particularly from the US. He cites bank HSBC, broker Tullett Prebon and United Business Media, which organises trade shows, as attractively priced businesses with diverse earnings streams that are growing profits and margins, and returning cash to shareholders.

‘The free lunch is over from blindly following small and mid-caps and bond proxies. Large caps with overseas earnings streams have been completely mispriced because of the events of the last five years, but they are the place to be over the next five to 10 years,’ Geffen said.

The new world

He believes investors must not focus on what has worked for the past five years, but rather think about how things are changing and what will do well in the future. Geffen views technology as a big growth area. The 33-stock portfolio currently has a 15% allocation to the sector, including Microsoft – which sits in the fund’s international allocation.

‘The world has changed. Technology disruption is going to be massive. Let’s benefit from some of those winners in an income fund,’ he added.

William Meadon, manager of the JPMorgan Claverhouse investment trust, agrees that many UK income managers have been caught off guard by the rotation out of bond proxies into cyclicals.

‘Clearly, this has taken a lot of active managers by surprise. Those who have adapted to the new world that we are in have done relatively better than those who have stuck with the trend that has been in place for the last 10 years,’ he explained.

Meadon has reduced his trust’s exposure to mid and small caps since the Brexit vote. He has also benefited from holding mining stocks since the beginning of the year and has slightly increased the number of economically sensitive stocks in the portfolio, following Trump’s election in the US. For example, he added to Ashtead, which rents out construction equipment, and receives a large portion of revenues from the US.

Likewise, he bought building materials company CRH, which stands to benefit from higher global infrastructure spend.

However, he doesn’t believe that it is necessarily a one-way bet for cyclicals. For this reason, he says a balanced portfolio is crucial, given the uncertainties facing the global economy over the next six to 12 months.

He holds traditional defensives such as British American Tobacco and GlaxoSmithKline in Claverhouse’s top 10, alongside Shell and Rio Tinto.

Over the past year, JPMorgan Claverhouse has returned 4.8% in net asset value (NAV) terms, which refers to the total value of the trust’s underlying assets. In share price terms, it is up 0.4%. Over three years, its NAV has risen 16.8%, while its share price is up 12.3%. It has a dividend yield of 3.7%.

This article is independently written by Citywire and not subject to editorial oversight by Blackrock