PA ANALYSIS: Harnessing the UK mid cap story

Can mid caps sustain their momentum during a more defensive point in the market?


This has been great for mid-cap specialist managers which are now riding high at the top of fund performance league tables, but has the sector’s strong run of form flattered weaker managers? Would a passive approach be just as successful a way to invest in the sector?

Some commentators suggest that a passive route is more appropriate if investors want a mid-cap bias to their portfolios. They argue the mid-cap sector is cyclical and tends to outperform at certain times in the business cycle. Managers find it tough to keep up when it rises and do not necessarily outperform when it falls.

But although there have been some weak funds, this view is not borne out by statistics, with most of the main mid-cap specialist funds beating the FTSE 250 over one year. Over three years – when the statistics include the exceptional growth in the mid caps as global corporate earnings recovered – it is around half-and-half. Over five years, most active managers again manage to beat the index.

Andrew Neville, manager of the Allianz RCM UK Mid-Cap Fund, argues: “The performance of some mid-cap funds relative to the FTSE 250 was impacted when the market rallied hard and it was difficult to keep up, but very few funds have consistently underperformed.”

What goes around…

The cyclicality argument is harder to defend. Clearly, the mid-cap sector does not have the old-fashioned defensives of pharmaceuticals and tobaccos and its cyclicality has been an important factor in recent outperformance.

But Derek Mitchell, manager of the Royal London UK Mid-Cap Growth Fund, points out that the recent success of the mid caps is not entirely down to its cyclicality. He says that the broader spread of businesses available in the index has also been helpful. Performance has also been boosted by the absence of banks and miners from the index, which have been a significant drag on the performance of the FTSE 100.

Equally, mid caps are a lot less cyclical than they were. Mitchell says that changes made by company management in the sector have reduced cyclicality and in many cases investors are now looking at genuine growth firms.

Neville believes the weaker engineers have been slowly whittled away – they have closed down or been taken over and investors are left with high-quality industrials. There is also less dependence on the UK.

On the defensive

The UK market has shown a market preference for more defensive firms this year as it has been confronted with a barrage of problematic economic data, a slowdown in China, ongoing problems in the eurozone and the earthquake in Japan. Could this be the end of the road for the mid-cap outperformance?

Neville believes the market is currently experiencing a mid-cycle slowdown and nothing more. He says a lot of the current worries – US debt, Greece – are red herrings and the global economy is likely to reaccelerate next year.

Haines, meanwhile, believes the market’s penchant for big sector calls is coming to an end. It will start to value self-help stories or firms with pricing power.

Some argue that a passive approach to mid-cap investing is best when the market is soaring, but it offers little defence if the market weakens. As the economy continues to weaken, it may be a less buoyant time for mid caps and, as such, may not be the best time to look at a passive approach. In general, active managers have proved their salt over the longer term.

A longer version of this article appears in the July issue of Portfolio Adviser