Smaller company funds are a useful option for larger UK portfolios offering diversity away from the main index constituents. Some of the strongest long term returns can be sourced from this area of the market but it brings with it higher levels of volatility.
This is not an area of the market we regard as core to a UK portfolio but it can be useful as an additional source of alpha. UK smaller companies funds are defined by the Investment Association as funds which invest at least 80 per cent of their assets into the bottom 10 per cent of companies by market cap.
Many small companies now have significant international sales and so the sector is no longer just a play on the UK economy, the wider universe allows good stock pickers ample scope to find both good performing sectors and companies. In addition many of the UK smaller companies have less gearing than their mid and large cap counterparts and therefore are more able to self-finance growth.
The last eighteen months (pre EU referendum) had been very supportive of mid and smaller cap holdings with such stocks posting stronger returns than FTSE 100 stocks. This however was reversed following the EU referendum as investors moved from mid and small cap stocks to safer large and mega cap stocks, although this move was relatively short lived.
Many investors felt that the more domestic bias of smaller-cap stocks would weaken their ability to improve earnings in a UK outside of the EU. In reality smaller-cap stocks proved to be slightly more resilient than mid-cap holdings in the sell-off, being less liquid than the larger FTSE 250 stocks, which were the first to be sold.
The recovery has still left smaller cap stocks at lower values than the larger more globally focused companies who have been more insulated from the fall in sterling, which has not recovered in the same way as stock markets have. The fall in the value of sterling could have both positive and negative connotations for the UK economy.
The positive is of course that UK goods become more competitive which is good for exports, however, imports become more expensive which is negative for our current account balance and in the short term could have the effect of increasing inflation above target. Since the vote however the central bank has worked hard to underpin the economy and the stock market has stabilised for the time being, which has been positive for most areas of the market but in particular the defensive less cyclical areas.
The UK economy was, like the rest of the world, looking towards a lower growth environment for the coming 12 months as global growth slowed, but earnings forecasts for UK companies have also reduced and unless this can stabilise or improve, market valuation levels are unlikely to move on to a higher trading range.
This has the same effect on smaller companies as well which tend to be more sensitive to changes in sentiment and economic data in terms of price movement. They will tend to have a higher risk premium attached to them than other areas of the market but if an investor is prepared to look beyond the short term fluctuations then a specific allocation to this area of the market is worth consideration.
The returns from the broader market over the last few months, up until this week, has been surprisingly strong and this has meant that despite the poor start to the year we have seen a recovery of sorts, although this has not been a universal one.
Areas hit hardest include banks and housebuilders and they have not recovered in the way that less cyclically biased stocks have done. More recently the Bank of England has tried to re-stimulate the economy by lowering interest rates and starting a corporate bond buying programme with the intention of building greater confidence for companies who are fundamentally important to the growth of the UK economy, as well as encouraging greater foreign investment.
The near future of the UK will of course be focused on the practicalities of exiting the EU and the trade deals that can be struck. It is therefore difficult to look longer term in such an environment but investors need to do so to avoid snap decisions based on sentiment led market movements.
Ken Rayner is investment director at RSMR.