The small size of small cap companies presents investors with a choice of balancing more risk with the potential for significant growth.
“The key advantage of the asset class is the higher risk-reward,” according to Neil Hermon, co-head of UK equities at Henderson Global Investors.
“Since these companies are growing from a lower base when they start building/taking market share off competitors, growth can really take off.”
But he admitted there was no such thing as a free lunch, as the potential for greater returns also comes with greater risk.
Adrian Lowcock, senior investment manager at Hargreaves Lansdown, says: “Smaller companies should be considered more risky.
“These companies are more sensitive to changes in market sentiment and economic outlook, so if the market falls smaller companies’ shares might fall further.
“Ultimately smaller companies are niche or start-up and therefore there is a greater chance that the business does not succeed and investors lose their investment.”
The smaller the company the more volatile the share price, as less trading volume is needed to move the price, Mr Hermon notes.
Clients must be able to accept a possible 5 per cent move in just a single day, so a greater tolerance for risk goes without saying.
Mr Hermon states: “Faith and patience are requisite virtues when it comes to small cap investing.
“Many small caps are younger companies with shorter track records and investors will need to take on a longer-term view to reap the returns of their investment.”
But small caps funds also offer access to an under-researched asset class. This can be a real plus for investors, but Mr Hermon stresses that it means the “track record and experience of the fund manager are key.”
Small cap teams such as his will have hundreds of company meetings a year.
“What we look out for are companies with strong growth models at the right valuation.
“These companies may take time to establish themselves, take market share and scale up their business. That is why we look at the growth potential of these companies over a four- to five-year time frame, rather than trading on short-term news. As a result our portfolio turnover is low, around 20 per cent a year.”
An adviser is unlikely to have the expertise or be able to dedicated the time required to run a portfolio of individual shares, therefore a collective fund would be the best option, according to Mr Lowcock.
He notes some discretionary fund managers offer portfolio management for Aim shares, but says in general “these are higher risk and probably only suitable to investors with much larger portfolios and once an investor has used up their Isa, Sipp and VCT allowance”.
Mr Lowcock adds: “I would suggest VCTs as another way to access some interesting small business and benefit from tax relief.”
