Marketing bias leads to small cap funds being overlooked

It showed that £100 invested in the Scottish Oriental Smaller Companies investment trust at the end of February 2003 would have returned £875 10 years later.

More impressively, that same £100 would have turned into £1,062 if invested in the Aberdeen Asian Smaller Companies investment trust.

I can’t help but think that the amazing ability of smaller companies to grow at a faster rate than their more established mega-cap peers is often overlooked

What is striking about the list is just how ubiquitous smaller companies are. The small-cap trust dominance isn’t restricted solely to Asia Pacific small-cap investment trusts – plenty of UK smaller companies trusts feature too.

In fact, of the list of 20 trusts, half of them have a reference to small caps in their names, with many of the others known to target small and mid-sized companies.

Wondering if this small-cap dominance was perhaps some quirk of the investment trust industry, I ran the same data for the Oeic and unit trust industry on the same timeframe, using FE Analytics.

The small-cap theme certainly does carry across to the open-ended top-20 list. Threadneedle European Smaller Companies returned £631 and Franklin UK Mid Cap paid out £597, for example. It bears mentioning that the trusts’ returns are better probably thanks to the vehicles’ ability to use ‘gearing’ – or to borrow money – to ramp up the amount of stocks they own and therefore fare better in positive markets.

You would expect small-cap focused funds to be putting in a good showing right now, since of course smaller companies do tend to shine in market rallies and they have certainly shone in the bull market of the past six months.

But still, I can’t help but think that the amazing ability of smaller companies to grow at a faster rate than their more established mega-cap peers is often overlooked in the UK fund market.

The focus tends to stay on the blue chip players – the Woodfords, the Buxtons.

Why is that? I think it’s because of capacity.

Fund managers that enjoy success on small-cap funds find themselves acting to reduce inflows very quickly, because the funds cannot be allowed to grow too large to trade effectively in ultra-illiquid small-cap markets.

Fidelity recently ‘soft closed’ its UK Smaller Companies fund at a remarkably small £280m, in a commendable example of a manager heading off the potentially dire effects of having to sell assets at very poor prices due to illiquidity.

Small-cap funds are doomed to mediocrity, in terms of their ability to generate revenue for managers, from the start and that’s why they aren’t promoted.

But for long-term investors these 10-year figures suggest they should be the first port of call.

John Kenchington is editor of Investment Adviser