Why small caps can still be effective

In the past 10 years as a whole, only a tenth of top quartile smaller companies funds have lost money, when assessed on a discrete annual basis.

Assessing the past 10 years on a cumulative basis, taking small-cap products listed in the IMA European Smaller Companies, Japanese Smaller Companies, North American Smaller Companies and UK Smaller Companies sectors, just 3.5 per cent lost money to the detriment of their investors.

The fact that small-cap stocks have historically outperformed their large cap cousins in the very long term has been well publicised.

This outperformance is strongest in the initial bounce at the beginning of a recovery but continuing well into the muddling-through phase. But statements like this can be slightly misleading. Speaking about the US equity market, James Abate, manager of the £22.4m PSigma American fund, says: “The underlying notion is that smaller companies offer better returns because that segment of the market is less efficient. While it’s true that smaller companies are covered by fewer analysts, the data supporting this case of outsized returns does not hold up to scrutiny of research.

“The evidence is that active small-cap managers have demonstrated no advantage in terms of outperforming their proper risk benchmark, the S&P 600 (Small Cap) or Russell 2000 indices, as compared with active large-cap managers against the S&P 500 index. Therefore, the first decision for investors into US equities should be deciding how much to dedicate to funds exposed to larger companies versus smaller companies followed by the second decision of manager selection.”

So far in 2012, it is UK and European small cap funds that have best served investors, delivering an average of 6.78 per cent and 4.86 per cent respectively.

A return of confidence

According to Baring Asset Management, this favourable environment for small and mid cap stocks was a result of a return in confidence and optimism in the eurozone at the beginning of this year following a period of exaggerated bearishness at the end of 2011, together with a bounce in mergers and acquisitions.

Nick Williams, manager of the Baring Europe Select trust, says: “Small and mid caps in the eurozone were hit particularly hard last year by negative sentiment in the markets, but year to date have outperformed large caps. This is largely due to the access that small cap indices provide to interesting, high growth stocks within the industrials, IT and consumer discretionary sectors in particular, especially within the capital goods subsector. On a country level, small and mid-cap indices have considerably outperformed large caps in Italy and France so far this year.”