Catherine Stanley, manager of the F&C UK Smaller Companies fund, says performance potential is the biggest advantage of a well-run UK Smaller Companies fund.
They can also add greater balance to a portfolio, as many mainstream equity fund offerings tend to be heavily biased towards a relatively small number of very large companies that dominate market indices from a capitalisation perspective, Ms Stanley says.
Smaller companies funds in particular also allow individuals to easily invest in a more diversified portfolio of smaller companies than they could readily achieve by themselves, she adds.
Ms Stanley says: “This is important as stock specific risk tends to be higher the lower down the size scale you go.”
The main pitfall of these funds is that they can serve to introduce a higher level of stock specific risk into a portfolio, says Ms Stanley.
She says this is because smaller firms don’t enjoy many of the advantages their larger competitors do, such as economies of scale and diversification of revenue streams.
Ms Stanley says: “This can make them more vulnerable during economic downturns or when competitors come onto the scene. Factors like this make stock selection especially important when investing in smaller companies.”
Liquidity can also be an issue. Compared to buying/selling shares in a large FTSE 100 listed company for example, Ms Stanley warns it may take a manager longer to build up a meaningful position in a smaller company or indeed dispose of shares.
She contends that there is a silver lining to this liquidity lack, though, arguing that if markets are falling sharply, “share prices in less liquid companies may prove to be more resilient than those that are more readily bought and sold”.
Smaller companies are less heavily researched, which Steve Kenny, head of retail sales at Kames Capital, says provides opportunities for good active managers to find undervalued and/or fast-growing stocks.
This gives smaller companies managers more opportunity to add value that managers of funds dominated by more heavily-invested companies, which often have high crossover of portfolio constituents to passive rivals.
But with this smaller companies can be riskier than larger companies and Mr Kenny says advisers should always remember they tend to be more volatile.
He says: “As they are often at an earlier stage of growth, their business structures can be less developed and their cash flows more unstable.”
