Two funds to play a UK mid-cap recovery

The underperformance of FTSE 250 listed stocks so far in 2022 has been notable. Morningstar’s Simon Dorricott explains why, and provides some fund ideas to play a return to form.

Over the course of 2022, we have seen a significant divergence in the performance of different segments of the UK equity market. The market has been impacted by investors’ concerns over rising inflation, interest rates and future economic growth that have been echoed across developed markets.

In the year to the end of July, the FTSE 100 index has seen a meagre gain of 2.7%, while the next 250 companies captured by the FTSE 250 index have declined by an alarming 12.7%.

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What has caused this performance gap?

To answer this question, we need to look at these indices in more detail and fully understand the exposures each is offering.

The first area to investigate is the sector exposure of the indices. The FTSE 250 has a much greater exposure to businesses in the industrials, consumer discretionary and IT sectors, while the large-cap index has a considerably greater allocation to energy, materials and consumer staples.

Related to the sector allocation is style. Using the Morningstar definitions of the growth and value styles, we see greater exposure to the growth style from the FTSE 250, something that has been persistent over time.

Therefore, the FTSE 250 generally shows a greater potential for earnings growth, reflecting the less-mature profile of some constituents, and valuation levels are consequently often higher. This style difference is reflected in the sector allocations, with many companies in the commodity sectors being classic value stocks and IT being an obvious growth sector.  

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The larger companies in the index are also more global in terms of revenue generation. The FTSE 250 is often described as having a domestic focus, which isn’t wholly accurate given that 45% revenue is derived from the UK. However, compared to the FTSE 100, which has just over 20% UK revenue, there is a clearly higher domestic focus that is also observable in returns.

Due to the underlying overseas revenue streams, the FTSE 100 will tend to outperform the FTSE 250 during periods of sterling weakness.

The relative exposures outlined above essentially explain the performance differential year-to-date.Over the course of the year, we have seen investors becoming more cautious, with concerns rising over inflation, the interest rate rises aimed at controlling it, and the impact on future growth. In this uncertain environment, investors have been increasingly unwilling to pay for future growth potential.

As a result, growth stocks have suffered, beneficiaries of inflation such as commodities have been sought, and safe havens such as the US dollar have been in demand. All this points to the underperformance of the FTSE 250 versus the FTSE 100.

Over the long run, the FTSE 250 has outperformed

Versus the FTSE 100, long-term historic returns (10 and 15 years) show outperformance by the FTSE 250, and longer-term earnings estimates continue to show higher growth from this part of the market, so there is potential for a reversal in fortunes.

This year, FTSE 250 valuations have fallen, improving the relative attractiveness of UK mid-caps. As a result, Morningstar Investment Management, which focuses on longer-term valuation opportunities, [has] increased its allocation to this area of the market. Our analysis now shows UK mid-caps as offering future returns in line with large-caps, expectations having been lower prior to the recent decline. Timing market moves is notoriously difficult, but, for long-term investors, UK mid-caps appear more attractive than in recent years and there may now be an opportunity to diversify away from large-cap stocks.

For those interested in this area of the market, there are options on the interactive investor Super 60 and interactive investor ACE 40 rated lists. The active managers with the highest UK mid-cap exposures on each list are the LF Lindsell Train UK Equity fund, which has a 40% allocation, and Janus Henderson UK Responsible Income fund, with 53% exposure.

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The Lindsell Train fund is managed by highly experienced manager Nick Train and holds a highly concentrated portfolio of companies (20-25) that he believes have high-quality, durable and cash-generative franchises. At the sector level, the fund reflects the biases of the FTSE 250 relative to the FTSE 100, with higher exposure to the industrials, consumer discretionary and IT sectors, but there is also a very significant bias to consumer staples reflecting the durable growth style. There is no exposure to commodity sectors.

As its name suggests, Janus Henderson UK Responsible Income aims to provide a good level of income to investors and employs ESG screening. It has a long-tenured manager, who is part of an extremely experienced income team. In terms of positioning, there is a bias to the IT sector relative to the FTSE 100 and the fund is underweight commodity sectors, both reflecting the positioning of the FTSE 250.

However, there are also significant biases to communication services and utilities due to the income approach, which also results in the fund having a neutral, or blend, investment style overall.

Simon Dorricott is direct of manager research, manager selection services, at Morningstar.