Get set for UK recovery with funds

You can't buy GDP, so if you also believe there is a recovery you need to choose investments which might benefit from these trends. FTSE 100 companies make around two thirds of their revenues outside the UK, so Jason Hollands, managing director at wealth adviser Bestinvest, suggests looking further down the market-cap spectrum to achieve greater domestic exposure.

Funds offering exposure to these areas include:

AXA Framlington UK Mid Cap (GB00B5032Q31). "The FTSE Mid 250 Index earns around half its revenues at home," says Mr Hollands. "This fund is a minnow at circa £37.6m, which we see as an advantage when focusing on a relatively narrow universe of stocks."

Currently about 80 per cent of assets are invested in the FTSE Mid 250. Large holdings include equipment rental firm Ashtead Group (AHT) (2.6 per cent of assets), property search engine Rightmove (RMV) (2 per cent) and building supplies firm Travis Perkins (TPK) (1.8 per cent).

For multi-cap exposure, Mr Hollands suggests Fidelity Special Values Investment Trust (FSV). "This trust is a way to access the stock picking skills of rising star Alex Wright who took over the reins from Sanjeev Shah in September 2012," says Mr Hollands. "The trust has a brief to invest across the UK market cap spectrum and the manager has a contrarian style, focused on identifying undervalued stocks with the potential to re-rate. It is important not to lose sight of fundamental value when parts of the market have started to look pricey. The trust is trading at a 4.07 per cent discount to net asset value (NAV)."

Mr Wright has an excellent performance record with Fidelity UK Smaller Companies Fund and since he took over Fidelity Special Values there has been a dramatic improvement in performance. (read more on this).

Read our tip on Fidelity Special Values

For mixed mid and small-cap exposure, Mr Hollands suggests Old Mutual UK Smaller Companies Fund (GB00B1XG7C26). "This fund is typically 40 per cent invested in mid-caps and 60 per cent in smaller companies and currently has a cyclical bias," says Mr Hollands. "Nearly 35 per cent of the portfolio is invested in industrials and 18.2 per cent in consumer services."

Also see our interview with the manager of Old Mutual UK Mid Cap Fund

For small-cap exposure with income he suggests IC Top 100 Fund Unicorn UK Income (GB00B00Z1S94). "Around 90 per cent is invested in smaller companies (with the remaining 10 per cent in mid-caps)," says Mr Hollands. "It has a focus on companies that generate a decent level of dividend. The portfolio is therefore very different from a typical income fund. For hard pressed income seekers, this could make an attractive foil to a traditional equity-income fund."

However, recovery is not certain. "UK stock prices are factoring in a lot of optimism and may have overshot a little," adds Mr Hollands. "The more domestically focused Mid 250 Index is looking pretty expensive compared to trend, buoyed in part by its exposure to house builders. A common sense approach of phased investing or buying on any dips may be better than piling in blindly on the back of positive data."

Recovery and M&A

Simon James, founding partner at wealth adviser Gore Browne Investment Management, believes the recovery will be more corporate than household driven and take place over the long-term. "Companies which have had to refinance and reorganise may do well over the next few years," he says.

For this reason he suggests recovery funds such as Schroder Recovery (GB0007893760) which is among the top performing funds in the UK All Companies sector over one, three and five years. It looks for firms that have suffered a major profit or share price setback, but which appear to have good long-term prospects and the potential for significant share price gains. Its managers take a three to five-year investment view.

He also suggests Investec UK Special Situations Fund (GB0031075665) which uses a contrarian, value, bottom-up investment approach to select undervalued, out of favour equities. It invests predominantly in the largest 350 UK listed stocks and typically holds them for four to five years. Stocks must have fallen at least 50 per cent in the last seven years in order to be considered for inclusion in the portfolio.

Temple Bar (TMPL) investment trust is run by the same manager, Alasdair Mundy, along the same lines as Investec UK Special Situations but has a much lower ongoing charge of 0.51 per cent, in contrast to 1.6 per cent. It trades at a slight premium to NAV of 0.82 per cent and yields 3.15 per cent.

JO Hambro UK Dynamic (GB00B4T7HR59) is among the top 25 per cent of performers in the UK All Companies sector over one, three and five years. The fund seeks good quality companies with strong franchises that are under-appreciated by the market, and the portfolio can have a growth or value tilt. It can include recovery/restructuring stocks and invests across the market cap spectrum, but requires companies to pay a dividend.

Recovery funds should be held over the long-term as the improvement in the companies they hold can take some time to come through. "These can outperform in down markets, though, because as their portfolios include bombed out shares when the market falls the bad news is already in their share prices," says Mr James.

Old Mutual UK Alpha Fund (GB00B96MWT53) is focused on pro-cyclical/domestic recovery themes and run by Richard Buxton, who had a successful track record with the Schroder UK Alpha Plus fund.

However Mr James is concerned about its high exposure to banks. "Banks are still massively under capitalised," he says.

Financials accounted for 23 per cent of this fund's assets at the end of July. However, if there is a UK recovery banks are considered to be a good way to get exposure to it. Bank of America Merrill Lynch says that banks, retail and real estate shares are the best plays for a UK recovery, and is overweight in these areas.

Another fund heavily invested in UK financials is Jupiter UK Growth Fund (GB0004792130), which is first quartile in the UK All Companies sector over one, three and five years. It has nearly 30 per cent of its assets in financials and the top holding is Lloyds Banking Group (LLOY) accounting for 8.2 per cent of assets. Barclays (BARC) accounts for 5.1 per cent and HSBC (HSBA) 4.8 per cent.

Investment trusts for recovery

Source: Morningstar

Performance data as at 23 September

Mergers and acquisitions (M&A)

The Office for National Statistics reports that the number of domestic acquisitions between UK companies in the second quarter of 2013 increased to 60 transactions, up from 38 in the first quarter, and a number of fund managers are also predicting an increase.

For funds which may benefit from increased M&A, broker Chelsea Financial Services suggests mid-cap and smaller cap funds as some of their stocks are likely to be takeover targets. It also suggests funds that have suffered due to low levels of M&A but which may soon start to recover such as M&G Recovery (GB0031289217) and Fidelity Special Situations (GB0003875100), which is also going to be run by Alex Wright.

M&G Recovery has not performed well over one, three and five years, in contrast to strong historic performance but could do better if M&A picks up.

Read more on this

Other possible M&A beneficiaries include Artemis UK Special Situations (GB0002192267) and AXA Framlington UK Select Opportunities (GB0003501581).

"The risk to funds that could benefit from M&A include that the trend doesn't turn and levels remain subdued, as well as general risks like the situation with Syria and global growth having a wobble," adds Chelsea. "All of these could spook markets and make companies nervous so they don't spend the cash. These funds are suitable for investors willing to take equity risk and investing for the long term."

Funds to play the UK recovery

Source: Morningstar

Performance data as at as at 23 September 2013