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Josh McCathie, manager of the VT Downing Small & Mid-Cap Income Fund, compares the total returns of various equity indexes over the last 20 years. Many investors do not appreciate that the FTSE 250 is the best performing index over that period, significantly outperforming the mighty S&P 500 by almost 20%.
Josh believes this part of the UK market will continue to offer compelling risk-adjusted returns potential and concludes that those who keep the faith will be well rewarded.
Intended for professional investors only
There is a chart I have been using within my marketing material for a while now which often surprises many and sparks a degree of debate. The chart in question maps the total return of various equity indexes in local currency over the last 20 years, i.e. capital returns including dividends received, and removing any impact of currency fluctuations. The main observations taken from this chart are firstly; two of the top three performing indexes are UK based (FTSE 250 and FTSE Small Cap), and secondly that the FTSE 250 is the best performing index and surpasses the returns of the S&P 500 by nearly 20%.
The chart in question for your reference:
However, this 20-year return profile can be broken down into a tale of two halves. Taking the start of the period 2003 through to the end of 2015, the FTSE 250 vastly outperformed the S&P 500 by a factor of almost 3x (301% compared to 115%). This built up a significant enough buffer to remain ahead after 20 years, because the 2016 through to 2023 period experienced the opposite outcome. The FTSE 250’s return of 31% vastly underperformed the 133% delivered by the S&P 500.
As highlighted above, the drivers of equity returns are capital growth and dividends received. Yet capital growth is a function of two elements; earnings growth and the multiple investors are willing to pay for those earnings. Whilst dividends and earnings are fundamental facts, the multiple element is somewhat more subjective in terms of being driven by sentiment. Looking at these three features in isolation, we can identify the sources of return. Over the period of 2016 through to the end of 2023, the FTSE 250 delivered 62% earnings growth, falling short of the S&P 500’s 86% earnings growth. In terms of dividends, the FTSE 250 generated 22% of its total return from dividends, compared to 20% for the S&P 500. Therefore, to get to a 31% total return for the FTSE 250, we can see that it witnessed multiple compression that deducted 53% from the total return. Conversely, the S&P 500 benefitted to the tune of 27% from multiple expansion. Or to put this another way, excluding the “voting machine” element of multiples, the underlying performance of both indexes is 88% for the FTSE 250 compared to the S&P 500’s 106%. Still shy of the S&P 500, but certainly more commendable.
It's also worth considering that the above figures are before adjusting for the significant number of UK takeovers in recent years. Or the fact that higher performers get promoted to the FTSE 100, or even considering the dilution of investment trusts on the FTSE 250’s earnings growth figure. Finally, on the flipside, we should consider the proportion of the S&P 500’s return that has been driven by the FANGs or now the Magnificent 7 rather than the index as a whole. For the avoidance of being accused of cherry-picking results, we will refrain from adding these adjustments but it certainly provides food for thought when considering the merits of the underlying performance of each index.
But aren’t these results to largely to be expected? A UK discount is warranted following the vote to leave the EU, and the FTSE 250 constituents are smaller and less important on the global stage than their S&P 500 counterparts and therefore warrant lower allocations and in turn lesser capital flows. Yes, and yes. But does it have to be all one-way traffic?
Given we are income managers we will reflect our thinking in reference to the IA Global Equity Income sector. The IA Global Equity Income sector only has 0.2% exposure to UK equities outside of the FTSE 100. This compares to close to 40% for United States exposure. This is understandable and we would never expect the relative percentage exposure of the UK and US to be equal. But does some consideration need to be given as to why three of the best performing major market equity indices of the last 20 years are viewed so differently? This isn’t a perfect example, and we accept global managers have a vast universe and generally focus on large caps rather than small and mid-caps. But given UK equity flows have been consistently negative for 32 consecutive months, it indicates something isn’t quite right.
Without trying to sound sour that the S&P 500 has been a tremendous place to invest over the long term, we must not lose sight that there are times that it can and has underperformed. Not least as recently as 2022 (let’s not talk about 2023). There have also been periods of ongoing underperformance even compared to US Treasuries. Schroders neatly summarised that 81% of companies that outperformed the US stock market (i.e. drivers of the market performance) in the last 10 years went through a period of underperformance lasting at least five years.
Looking outside of the US, there have been episodes historically of past returns being extrapolated that failed to materialise. Holders of the Japanese Nikkei 225 have only just surpassed the 1989 peak, or closer to home, the FTSE AIM All Share has failed to even come close to its 2000 peak level.
There are many factors affecting markets, and to differing degrees. What has worked in the past won’t necessarily work in the future to the same extent.
To put our thinking into numbers, the three-year consensus earnings growth for the FTSE 250 and S&P 500 are 42% and 44%, respectively. Cumulative forecasted dividends for the S&P 500 are 5% and 14% for the FTSE 250. So, both indexes are offering compelling returns potential over the next three years, albeit slightly higher for the FTSE 250. However, the FTSE 250 currently trades on a forward P/E multiple of 11x compared to its ten-year average of 16x*. A re-rating towards 16x could enhance returns by a further 45% resulting in a total return of 101% over the next three years. The S&P 500 currently trades on a forward P/E multiple of 23x vs a ten-year average of 19x*. Moving back towards a ten-year average valuation would result in a total return of 32%; still not a bad return and certainly helps pose a question around allocations when in the pursuit of the best risk-adjusted returns.
This is purely theoretical and there are arguments to suggest none of the above will play out and justified multiples will be in a vastly different place than the ten-year average in three years’ time. But if the future even gets remotely close to rhyming with history, it suggests that those exposed to the FTSE 250 will be handsomely rewarded, just as current holders have been over the last 20 years.
Fund Manager, VT Downing Small and Mid-Cap Income Fund
*2020 excluded from 10 year averages.
This document is intended for investment professionals only. Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing available from Downing or from the ACD, Valu-Trac; your attention is drawn to the risk, fees and taxation factors contained therein. Please note that forecasts and past performance are not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested.
This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is a trading name of Downing LLP. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
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