UK funds are making a comeback, but remain unloved by investors

Over the past year, UK funds have been among the top-performing equity sectors.

The UK stock market has kept its head above water since the start of the year, bucking the wider trend, while various other international markets – most notably US indices – have posted losses.

But this has not been a flash in pan, as UK funds have performed well over the past year. From 31 January 2021 to 31 January 2022, the UK Equity Income sector has been the second-best sector, up 18.8%, and beaten only by India/Indian Subcontinent, with an average return of 28.2%.

Of the 21 fund sectors that exclusively invest in shares, UK All Companies and UK Smaller Companies are ranked fifth and seventh, with average returns of 13.9% and 12.8%.   

This represents a change in fortunes, as over a three-year time period, two of the trio were among the worst-performing sectors. UK Equity Income and UK All Companies rank 19th and 17th, with returns of 20.4% and 23.1%, while UK Smaller Companies was the eighth best-performing sector, with an average gain of 44.8%.

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Despite improved performance, investors have continued to shun the UK market. Over the past year, UK equity funds across the three sectors have seen inflows in only three months. The latest figures from the Investment Association (IA) for December show that £899 million was withdrawn from UK funds.

The UK market has been out of favour with fund investors since the UK voted to leave the European Union in June 2016. At the time, uncertainty over how Brexit would pan out and the prospect of the UK walking away from the EU without a deal, unnerved investors.  

Two years on from Brexit day (31 January 2022), sentiment towards UK funds has not improved. In fact, investors were heavier sellers of UK funds in 2021 than in 2016 when the Brexit vote took place, with £5.3 billion withdrawn versus £4.9 billion.  

The continued apathy towards the UK has left various fund managers perplexed. Nick Train, for example, manager of Finsbury Growth & Income (LSE:FGT) investment trust, told interactive investor’s head of markets Richard Hunter in a recent interview that “the UK market has been unfairly neglected in recent years”, and that UK companies are “undervalued relative to their global peers”.

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According to Train, the valuations of UK companies with a strong digital presence would attract higher price tags if they listed in the US. Train has previously observed that there’s been plenty of takeover fever among UK companies, with US companies and private equity firms viewing the UK as a good place to do business on valuation grounds. 

In recent weeks, the market has been rotating towards value shares, which tend to be more economically sensitive and benefit from higher interest rates. At the other side of the trade, many growth and tech shares have come under the cosh. With US interest rate rises looming, investors are questioning the high valuations of such stocks.

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The return to form of value shares has benefited the UK market, as it is more economically sensitive than other exchanges. Value sectors – oil, gas, miners and banks – comprise a large part of the FTSE 100’s market cap. 

David Jane, a multi-asset fund manager at Premier Miton Investors, says that the UK’s recent strong relative performance is a consequence of industry mix, rather than investors having any particular view on the outlook for the UK economy.

He says: “The real weakness in markets has been in the high growth and high valuation areas, such as technology, as interest rate rises begin to bite. The growth versus value debate is very heavily entwined with the interest rate outlook. Rising bond yields are bad for long duration growth stocks and vice versa. The UK has a paucity of growth stocks, especially in the tech arena, compared to most other indices.

“On the other side of the coin, the current year has seen strong performance from areas such as financials, energy and materials. Energy, for example, is less than 4% of the global index, but BP (LSE:BP.) and Shell (LSE:SHEL) alone are over 10% of the UK benchmark. The same is true for mining and banks. Performance of these areas is heavily intertwined with the growth versus value debate, which itself is heavily impacted by the inflation outlook.”

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Jane adds that whether the UK continues to outperform other global markets isdown to whether inflation persists. His view is thatthe current very high levels of inflation are unlikely to persist, but in the coming years it is likely that inflation will remain higher and prove to be more persistent than in recent years.

He adds: “This comes down to a number of factors, including government spending, de-globalisation, ESG policies and the re-emergence of the global consumer following a decade of deleveraging.

“If that proves to be the case, we expect those sectors that are so important to the UK market to continue to outperform over coming years. Also, in a more inflationary environment, bond yields are likely to be on a rising trend, crimping the performance of growth sectors. In contrast, the earnings and valuations of inflation-beneficiary areas will be seen as attractive, following many years of underperformance.”