The discretionary Managed Portfolio Service (MPS) team at Square Mile has started buying actively-managed UK equity funds for the first time in almost a year, having allocated most of its UK equity exposure to passive funds at the start of 2018.
Jason Broomer, head of investment at Square Mile Investment Consulting and Research, said last year was the first time the firm has ever allocated more than half of its UK exposure to passive vehicles, due to what he described as "increasingly irrational" market conditions.
"Ultimately, Square Mile prides itself on finding active managers who outperform over the long term, but occasionally, there are periods where market conditions are not conducive to active management. We recognised 2018 might be one of those periods, hence the switch," he explained.
"Looking back over my experience in the industry, there have been a couple of occasions where funds we favour didn't achieve results we are expecting.
"Usually, over any one year, we expect around one-third of funds to underperform and two-thirds of funds to outperform, but near the end of 2017 two-thirds of our funds were actually underperforming.
"This has happened to me a couple of times over the years - typically near the tail-end of bull markets. There is no point trying to fight a losing battle, so we made the decision to switch to passives."
Overall, about 60% to 70% of the MPS' UK exposure was held in passives last year, while 30% to 40% remained in active funds, which had already been purchased prior to the start of the year.
One of the passive vehicles the team used was the iShares UK Equity Index fund, which Broomer said outperformed 70% of active funds in the IA UK All Companies sector in 2018 after charges.
"Political risk in the UK made it difficult for fund managers to adapt, while markets had also started to mature," Broomer explained.
"People see share prices go up, want to get involved and buy into the stocks that have already gone up the most. Momentum trends were getting baked into markets.
"Meanwhile, some of our smart-beta strategies were by far the strongest performers. This is why we made this decision."
However, the team decided to re-allocate back into active funds at the start of 2019, due to the belief that last year's market correction should have helped to break any momentum trends.
Broomer added that the UK is gradually nearing the end of "tortuous" Brexit negotiations, which should mean some UK political risk subsides.
The head of investment could not name the active funds he is buying into as trades have not yet been completed.
However, the team will continue to hold the only two actively-managed UK equity funds they used throughout 2018: Nick Train's LF Lindsell Train UK Equity and Ben Whitmore's Jupiter UK Special Situations.
"We held both of these throughout last year, and thankfully they both managed to beat the FTSE All-Share index; particularly Train's fund.
"It was purely coincidental these funds performed well over 2018, because they are in our portfolios as very long-term plays,"
"We were in the right place at the right time, although we do expect these funds to continue to perform well."
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