UK Fund Flows: Bad, but Not as Bad

Last year saw the largest outflows from UK mutual funds and ETFs on record—although the good news is that 2023 is only the second worst year for flows, the worst being the previous one.

More than £57bn was redeemed from UK mutual funds and ETFs in 2023. However, almost £40bn of this was from money market funds (MMFs), drip feeding back into the market after the post-September 2022 mini-budget dash to cash. That seems to have hit bottom at the start of the fourth quarter, and MMF flows at long last turned positive, in line with their European peers.

Chart 1: Asset Class Flows by Year, 2004-2023 (£bn)

Source: LSEG Lipper

With the yield on cash increasing, in major European markets ex UK, USD and EUR MMFs had taken about £170bn, in stark contrast to what was happening with their sterling peers.

Equities struggled…

Despite the world skirting recession over the year and equities keeping their head above water, it’s not been a great year for the asset class, with almost £30bn of redemptions. That’s not been a uniform trend, with global equities seeing positive flows of £6.16bn. The most popular single equity region or country over the year was Japan, netting £1.17bn. Returns for Equity Japan have been respectable, at 14.74%, but still lagging those of Equity US for the year, at 20.09%.

The FTSE 100 was up 7.9% over the year on a total return basis, compared to 19.2% for the S&P 500. The returns of the latter were driven by the Magnificent Seven mega caps. Excluding these, the S&P 500 returned just 4.5%. Regarding US and European equities, unless you’ve had significant exposure to these seven, you’ve probably been lucky to keep pace with inflation. In terms of style effects, it’s unsurprising that large-cap growth has been the only game in town. But, longer term, there have been significant style rotations from one year to the next: over three years, value dominates, as in 2022 these tech titans tanked.

Despite the standout performance of the Mag7, US equity funds have suffered outflows of £431m, although the trend turned positive in the second half of the year. It’s also been another year of misery for UK equity funds, whether large or small, vanilla or income, with total outflows of nearly £2.4bn.

… as bonds bounced back

It’s been a different story for bonds, which saw inflows of £10.6bn, rebounding from dire performance over 2022. Unsurprisingly, because of narrow spreads, high grade and government bonds have attracted much of this cash, plus longer duration flows picked up from Q4, as the expectation that rates have peaked became engrained.

What unites equity and bond funds, however, is the ongoing rotation from active to passive, with the trend driven by cost and transparency. Passive equity fund flows stayed positive (£1.16bn) over the year despite the negative sentiment for the asset class, with active funds bearing the brunt of this in terms of redemptions (-£24.13bn). The real success story for passives this year has been with fixed income vehicles, where passive mutual funds netted £11.64bn, and ETFs £6.25bn, as their active equivalents suffered outflows of £7.61bn (chart 2). Despite the insistence of active managers that this market, with many corporates bloated with debt after a decade and a half of de facto “free money,” investors are less convinced, instead attracted by low cost and relative transparency in an unpredictable market.

Chart 2: UK Asset Class Flows, Passive and Active Mutual Funds and ETFs, 2022 (£bn)

Source: LSEG Lipper

Indeed, since 2004 the percentage of mutual funds and ETFs invested passively has risen from 7.08% to 26.05%, and this trend shows little sign of abating (chart3). Whether this will still be the pattern when defaults bite remains to be seen.

Chart 3: UK Passive and Active Mutual Funds and ETFs, Relative Net Assets, 2004-2023 (%)

Source: LSEG Lipper

Future challenges

That’s hindsight: the easy bit. Where is the fund market heading?

The US, despite fears to the contrary, skirted recession throughout 2023. Much of that economic support has been from US consumer spending, as they poured the savings they’d squirreled away over Covid back into he market. However, those excess savings are now gone. An additional negative factor may prove to be the lag between monetary policy changes and impact—typically 12 to 18 months. That implies that next year will be challenging, even if rates do head down.

On the plus side, the investment from President Biden’s Inflation Reduction Act may well pump prime the economy, keeping it afloat over the coming quarters. Further, US election years tend to be positive in economic terms as the President splurges largess to ensure he stays the President. So US equities may not be tapped out quite yet, and more even for the Mag7, as analysis suggests that these stocks may have further to run.  Certainly—and despite the negative flows for the classification overall—that flows turned positive towards year end shows that investors are increasingly convinced of the story.

A stable but higher rate floor is likely good for bond returns, though the important caveat here is that it will inevitably see higher defaults, not least in the high-yield market. Defaults have been heading northwards, and more companies are due to return to the market for finance in 2024 than in 2023 (though not as many as are due in 2025). But the higher yields have proven attractive to investors, as the flows indicate. This could also lead to a lower buying pressure for equities, as investors can get greater income from bonds, with the latest yield for the 10-year gilt about the same as that of the FTSE 100. This will be supportive for fixed income, and I’d expect to see bond fund flows stay in the black.

One positive for UK equities is that these higher rates could work in their favour, the UK being more of a value market, and therefore one that should do better in such an environment. What’s more, the market is cheap, and not just for value stocks, as FTSE Russell research indicates that forward P/Es for all factors remained well below 10-year averages in absolute terms, unlike in the US. Nevertheless, as things stand, performance has favoured US and global equities relative to the UK, and this will likely see investors continue to favour overseas plays, unless something significant happens to catalyse UK outperformance.

This article first appeared in the spring edition of Personal Finance Professional.