Small but perfectly formed over time

The downturn has hit smaller company equities hard in the past six months but the picture is different over the longer term - figures reveal the sector consistently outperforms large caps.

UK Smaller Companies funds are a core component of investors’ long-term financial security and they are adjusting to circumstances with reduced exposure to financials and increased technology holdings. Astute investors should wait for the wider economic shocks to complete their journey through the economy before extending their small-cap fund investments when valuations are yet deeper.

Smaller company equities have been hit hard over the past six months. While the FTSE 100 Total Return index of large cap stocks lost a painful 12.33% during the six months to the end of September, this bearish strain was even more pronounced in smaller stocks. The FTSE 250 Mid Cap Total Return index lost 19.49% and the FTSE Small Cap Total Return lost a similar 19.19%.

The picture is different over longer time horizons. The mid caps managed a 128.69% total return on a 10-year basis and the small caps generated 56.47% total return, and all this while the large-cap FTSE 100 left its index with only a 31.77% total return. Studies of the past century’s returns have consistently supported the fact that long-term investors’ best equity returns are generated by holding smaller company stocks and value stocks.

Smaller companies are at the forefront of the creative destruction at the heart of the capitalist system that selects the fittest new ideas that contribute to long-term GDP growth. Individual small and mid-caps can be riskier than a blue chip stock, but a broad basket can capture the phenomenon. In short, a sensible investor’s portfolio must be diversified and contain a wholesome exposure to smaller companies, preferably bought at times when valuations are beaten down.

Equity market returns are one thing, but fund returns are another. An actively managed fund, like any non-passive fund, will be able to outperform or underperform its benchmark and the wider market. This differentiation depends on procuring the manager skill that is, by definition, hard to come by. Funds have the freedom to differ from each other in terms of exposures, timing, how they manage their risks and how they scale into or out of positions. Only looking at market indices is insufficient.

So how have these funds panned out over the long term? Fund sector indices are a good starting point. The Investment Management Association (IMA) UK Smaller Companies sector achieved a 102.65% return over the past 10 years, healthily bridging the top end of the equity market returns of the mid-cap and small-cap sectors and surpassing the performance of UK All Companies (40.71%). The IMA North American Smaller Companies sector attained a 68.04% return over the same period, versus the 11.05% return of the larger-cap IMA North America sector.

The IMA European Smaller Companies sector also pushed ahead of the wider market funds, with a 146.59% 10-year return, versus the IMA Europe excluding UK sector’s 69.51% showing. Both UK and North American Smaller Companies funds have lower value at risk (VaR) metrics versus their larger-cap sectors over the past 10 years. This means that on any given month, the larger-cap fund sectors’ worst losses have been worse than the smaller-cap fund sectors.

It has been suggested that the risks of small-cap investing outweigh the benefits. Like many sectors or asset classes that have obvious alternative choices (value versus growth or stocks versus gilts) rotation does take place between styles and so large caps or small caps can be in or out of fashion. Larger-cap funds are also less volatile on average and during hard times smaller companies can pay dearly. Timing becomes more important when investing with a specific level of company size in mind, particularly if the investment is less than long term.

During the recent crises, the variety of returns attained by larger and smaller-cap funds was fairly similar. This is supportive of the benefits of small-cap investing despite the fears mentioned above. With almost five times as many funds to choose from, the UK All Companies sector did have more of a chance for better performance and its top performer did scrape a 2.87% return over the year, versus the UK Smaller Companies’ best fund performance of a 9.58% fall.

Yet if the year-to-date performances for each fund in the IMA UK All Companies sector are compared with the UK Smaller Companies sector, the average and bottom fund performances for both sectors are similar. More importantly, the returns on the funds that investors would have most likely chosen were similar between large and smaller-cap funds. Excluding 2008’s top 10% and bottom 10% of funds from each sector – to cut out extreme luck or misfortune by only looking at the 80% of funds in the middle of each – reconfirms that the manager risk profile of both sectors is similar.

But what have these UK Smaller Companies funds been doing over the year? There has been an increase in technology holdings of the average fund from 10.9% to 12.7%, a sector that has re-entered the investment radar over the past two years. The dominant theme was the market turmoil. Basic materials witnessed an increase from 4.2% to 4.9%, a 15.76% increase in value.

This was mirrored by the reduction in financials, the largest absolute shift in portfolio holdings. This allocation reduction, from 14.2% to 12.3%, was a 13.34% cut in the value of financials exposure. Consumer goods saw a deeper swing in bearish sentiment, cutting the value of the exposure by 23.69%, based on its fall from a 4.2% to a 3.2% holding for the sector. These shifts in fund holdings were expected in the credit and inflationary environment. Investors who watch these evolve as the crisis pans out can be one step ahead.

RICHARD RAMYAR Head of research, UK and Ireland at Lipper