What needs to happen for fund investors to buy back into the UK?

The sales statistics for UK equity funds make grim reading. UK funds saw £14 billion of outflows in 2023, making it eight consecutive years of investors pulling out their money.

Valuations alone haven’t been a catalyst for a change in fortunes. Over the past couple of years, the UK market has been trading on cheap valuations versus its own history and compared to international markets.

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So, what needs to happen for the tide to turn? It is a question we regularly ask UK fund managers for our Insider Interview series.

Below, we round up some potential catalysts cited in recent interviews.

The ‘Magnificent Seven’ rally running out of steam

Since the start of 2023, the performance of a small number of US technology stocks, known as the “Magnificent Seven”, has been responsible for most of the US stock market’s return. By extension, global stock markets have also been boosted.

Excitement over the potential of artificial intelligence (AI), which is predicted to shake up various industries, led many investors to the US stock market at the expense of UK equities. The seven stocks, including NVIDIA (NASDAQ:NVDA), Microsoft (NASDAQ:MSFT) and Meta Platforms (NASDAQ:META), comprise almost 30% of the S&P 500 index.

Alex Wright, fund manager of Fidelity Special Values (LSE:FSV), one of interactive investor’s Super 60 investment ideas, says: “Because of the outsized performance of the US market, it really has sucked capital away from most other capital markets. And since the UK is a very large market, despite the fact that the number of companies has been shrinking, [it] has definitely been in the crosshairs of that.”

According to Wright, if the Magnificent Seven’s purple patch ends, this could prompt investors to be more cognisant of valuations.

Wright says: “If we do see a correction in the US market, I think that could be the catalyst for a UK re-rating as people think a lot more about valuations rather than the momentum that has really been driving stock markets over the last couple of years.”

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Sue Noffke, head of UK equities at Schroders and manager of investment trust Schroder Income Growth (LSE:SCF), agrees that a pullback in share prices for the US tech giants could act as a spur for investors to re-examine their UK exposure.

She says: “There’s only been one game in town and that’s US equities. Even within US equities, it’s been the Magnificent Seven, those large, hyper-scale tech stocks. If we see any crack in that, or an ability for people to think ‘I want some diversity in my portfolio at an asset allocation level’, that could stop the outflows from UK equities. The reasons are very similar if you look at Europe and Asia-Pacific as well. So, if you just stop that magnetic draw into US large-cap tech, I think other markets have a chance.”

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The peaking of the interest rate cycle

The peaking of the interest rate cycle and inflation continuing to cool could spark a turnaround in fortunes. Data from Martin Currie shows that when interest rates peak, this has historically led to notable outperformance for UK mid-cap shares, which are more domestically focused.

The research found that between 1985 and 2022, the average FTSE 250 index return after rates peaked was 12.3% over one year (2.1 percentage points ahead of the FTSE All-Share Index); 20.3% over three years (5.5 percentage points); and 31% over five years (10.9 percentage points).

Richard Bullas, manager of the FTF Martin Currie UK Mid Cap fund, says that “like a coiled spring, when sentiment starts to shift the market will move quickly”.

Rebecca Maclean, manager of investment trust Dunedin Income Growth (LSE:DIG), agrees that a change in direction for interest rates could create a “tailwind” for investor sentiment towards the UK market.

She says: “There are some underlying fundamentals in terms of interest rates and inflation metrics, which have been a headwind to risk assets, including UK equities. We’re starting to see them turn and be more supportive. Some of those headwinds should start to decrease. We are seeing inflation coming down, it’s easing. We’re seeing what looks like peak interest rates and that should be supportive too.”

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Stuart Widdowson, manager of Odyssean Investment Trust (LSE:OIT), agrees that interest rate cuts are “one of the potential catalysts”.

He says: “Historically, as interest rates have been cut, risk appetite improves, and asset allocators do look at smaller companies in a broader way than they might have done in the past. The whole flows issue is quite important generally, because certainly we do find that there tends to be a domino effect, [where] one or two things happen [and] people change their minds." 

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Other potential catalysts

A longer-term catalyst for boosting investment in the UK market would be a reversal of the trend of UK pensions reducing exposure to our home market. In 1993, final salary pension schemes invested 57% in UK equities. That allocation was 48% by 2000, falling to 31% by 2010, 16% by 2015 and reaching a paltry 6% by 2022.

A boost may also come from the £5,000 “British ISA”, which was announced as part of the Spring Budget. As explained in a recent On The Money podcast episode, there are both pros and cons to this new ISA. While the details have not yet been ironed out, it will result in more money being invested in the UK. The question is whether the number of people investing in a British ISA will be sufficient to move the dial. The likelihood is that only those who currently maximise the £20,000 ISA allowance - around 15% of ISA investors - will utilise the extra allowance.

A bigger game changer would have been the removal of stamp duty on UK shares, including investment trusts.

Other potential catalysts for reviving the fortunes of the UK market include a pick-up in M&A activity and new stock market listings, or IPOs. For the former, activity appears to be picking up, with electrical goods retailer Currys (LSE:CURY) rejecting a bid from US investment group Elliott, while FTSE 100-listed packaging firm DS Smith (LSE:SMDS) is in takeover talks with US firm International Paper (NYSE:IP).

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Share buybacks can also have a positive impact. Richard Hunter, head of markets at interactive investor, says: “Companies repurchase their own stock, which means there are fewer shares in circulation. This should immediately improve the earnings per share (EPS) number as earnings are divided by fewer shares.

“All things being equal, this should also lower the price/earnings (PE) ratio, which is a key metric for potential investors. The stock therefore becomes ‘cheaper’ and is likely to lure more investors.”

For investment trusts, share buybacks can also prove beneficial in reducing discounts, which occur when an investment trust’s share price is trading below the value of the underlying assets held in the portfolio, the net asset value (NAV).

Peter Walls, manager of the Unicorn Mastertrust fund, says: “Reducing the number of shares in circulation through share buybacks can help a discount to narrow, as it can push up a share price and provide positive momentum.”

At present, the average UK All Companies and UK Equity Income sector trust discounts are -11.8% and -7.5%.

However, Walls says the biggest catalyst for the UK market would be pension funds increasing exposure to UK assets. “Even if pension funds increased exposure by one percentage point, it would be a significant change for fund flows. The UK market’s low valuation provides a fundamental reason [for such a step].”