June 23, 2011 7:14 pm

Small cap funds have big results

Investors in search of higher returns have turned to smaller companies in recent months due to their robust performance, but experts warn that the sector may be ripe for a correction if the economic recovery stumbles.

Smaller companies have risen over 24 per cent in the past year, as measured by the RBS Hoare Govett Smaller Companies (HGSC) index, compared with a 9.6 per cent rise in the FTSE 100. Since the start of the year, smaller companies have outperformed the index by 6 percentage points, rising 4 per cent against a 2 per cent drop on the FTSE.

“The outperformance of the FTSE by the HGSC index is nothing short of stunning,” says Dan Nickols, head of the small and Midcap desk at Old Mutual Asset Managers. His fund rose 32.5 per cent in the year to June 2011.

Other small cap funds have also produced attractive returns over the same period. BlackRock UK Smaller Companies rose by 43 per cent, Cazenove UK Smaller Companies increased by 54 per cent, and Standard Life UK Smaller Companies is up 48 per cent.

Nickols says the rise in small cap returns has largely been driven by the “dynamism” of smaller capitalisation indices.

“[These] are constantly refreshed by a stream of IPO, M&A, promotion and demotion activity, compared to the FTSE which tends to be more static,” he says.

His fund is currently invested in companies such as Carphone Warehouse, software company Aveva, Telecity and Rightmove. “This sector is not dominated by mega-sectors or stocks, but represents a pool of less mature, more growth-orientated businesses,” he says.

Advisers say that companies in this sector tend to fare well in the period coming out of a downturn.

“Smaller companies are usually more dynamic and have greater growth potential than larger firms, which are often at the consolidation stage of their development,” says Patrick Connolly, at Chase de Vere Investments.

However, he warns that while smaller companies will outperform larger ones in good times, in bad times they tend to do worse.

“Performance of smaller companies is also more volatile and they can suffer large downturns in adverse economic environments as they are over-sold, as we witnessed in 2008,” he says.

“The illiquid nature of these stocks also pushes prices down further as investors seek security in more difficult times.”

The question on most investors’ minds is whether smaller companies funds will continue to outperform. A lot rests on the continuance of a UK recovery.

Alex Wright, manager of Fidelity’s UK Opportunities fund, believes it is still very early in the current economic recovery but thinks the current, reasonably stable environment will be enough to favour smaller companies as corporate expenditure starts to pick up.

“Increased availability of finance at low rates - not withstanding the criticism over Project Merlin missing its lending targets - will also lead to smaller companies becoming better placed,” he says.

But some advisers are less sure. “It is difficult to say whether, over the short term, UK Smaller Companies funds will continue to outperform because there has been a lot of noise about short term risks to the stock market,” says Tom Biggar, head of investments at TQ Invest.

“Sovereign default, such as Greece needing to be bailed out by the eurozone, remains a concern,” he says. “As is the impending end of the second round of QE which could mean, if history repeats itself, another drop in markets.”

Some advisers are now selling holdings in smaller company funds in favour of larger caps. “The outlook for a smooth recovery is uncertain....as such we currently prefer more defensive large cap companies,” says Adrian Lowcock, senior investment adviser at Bestinvest.

Advisers recommend that investors hedge their bets on a continued economic recovery by holding both larger and smaller companies, as part of a diversified investment portfolio.

“This can be a volatile sector so investors may wish to consider more defensive funds as part of their overall portfolio,” says Edward Johnson, head of discount broker Willis Owen. He suggests that the greater risk of smaller companies means that they should make up a lesser part of most portfolios.

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