Long-term advantages of small-cap investment

However it is important to remember performance of equity markets - whether one is looking at US or UK, large-cap or small-cap - is always cyclical.

This is the warning given by Jenny Jones, manager of the £1.37bn Schroder US Mid-Cap fund, who says: “There are cycles of out and under-performance of small versus large-caps.

“After a considerable period of small-caps outperforming, we have seen the tide shifting in favour of large-caps over the past few years.”

However, Ms Jones says it is important to remember long-term investing means more than just three to five years, and for patient investors, putting money away now into small caps can reap rewards over the real long-term.

The beauty of small and mid caps is companies can grow, even in markets which are flat, by growing market share Darius McDermott

She explains: “If one looks at the long-run studies of small versus large, there is a decided advantage in favour of small for patient investors.

“Over time, small and small-to-mid-cap companies compound at a higher rate than large cap, with the result they are good vehicles for long-term wealth creation.”

However, this does require investors to be able to stomach short-term periods of volatility in the portfolio.

Ms Jones cited updates by Ibbotson Associates - part of Morningstar - which puts out yearly reports on compound annual returns of US asset classes.

Over the past 90 years US small-cap companies would have provided significant returns (in dollars) for investors.

A graph from Jupiter Asset Management and Morningstar shows more clearly how US small-caps would have performed for the average UK investor from 1970 to 2013 - along similar lines to the Ibbotson figures for the US investor.

Source: Morningstar/Jupiter

Darius McDermott, managing director of Chelsea Financial Services, says: “The benchmark contains 2,500 companies operating in the largest and most dynamic economy in the world, so there are always good investment opportunities to be found.

“The beauty of small and mid-caps is companies can grow, even in markets which are flat, by growing market share.

“Again, the same as with any small-cap market, it is easier to double the sixe and profits of a £100m business than a £100bn business - the growth potential is bigger.”

“In my view”, says Robert Siddles, manager of the £159m Jupiter Smaller Companies trust, “the key advantage of US small caps over large is better long-term performance.

“The short-term investor needs to take more account of market volatility and so should probably favour large caps.

“The long-term investor, however, can be more sanguine about volatility and can hold small caps for better long-term capital appreciation potential.”

We’re also seeing a reversal in small-cap’s favour in the second quarter of 2016, when small-cap outpaced large-cap

This view is shared by Francis Gannon, co-chief investment officer of The Royce Funds, who says: “We’re comfortable as contrarian small-cap investors.

“In addition, we’re also seeing signs of a reversal in small-cap’s favour in the second quarter of 2016, when small-cap outpaced large-cap. More importantly to us, however, is the shift within small-cap from growth to value.

“We’re very pleased to see approaches like our core quality strategy out in front of the small-cap market so far in 2016.”

Where are advisers and brokers advocating putting clients’ money?

Mr McDermott, who is also the founder of fund rating firm Fund Calibre, likes the £319m Hermes US Small-to-Mid Equity fund.

He also believes Jenny Jones’ Schroder US Mid-Cap fund, which she has managed since 2005, will weather the Brexit storm well.

The fund, however, is not in the IA North American Small Cap sector but has been put into the Investment Association North America sector.

Mr McDermott says: “Run out of New York, this fund has a small and mid-cap focus and stands out from the crowd for the manager’s stock-picking prowess.

“Despite it targeting smaller companies, the fund is set up quite cautiously and has a disciplined investment process that has held up well in tough markets.”

Sheridan Admans, investment research manager at The Share Centre, also rates the Schroders Mid-Cap fund: “This fund is suitable for those investors wishing to add diversification to a US holding away from the mainstream large cap funds.

“It offers an investor the opportunity to benefit from potentially higher growth of small-mid size companies compared to large-cap peers.”