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Nature of small caps and small cap funds

This article is part of
Guide to Investing in Small Caps

The smallest companies are certainly small caps, but not all small caps are small companies.

Some small caps are quite big, as the definition is relative to the size of the market.

Neil Hermon, co-head of UK equities at Henderson Global Investors, says while the definition is subjective, generally in the UK companies that form the bottom 10 per cent in terms of market capitalisation are denoted as small caps.

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For example in the UK smaller companies are those that are outside the FTSE 350, meaning currently ‘small cap’ in the UK would a company valued at less than £400m.

In the US small caps are much larger, Adrian Lowcock, senior investment manager at Hargreaves Lansdown, notes.

Companies with valuations of between £300m and £4bn could be considered small cap in the US.

Many companies in the small cap space are relatively new firms or start ups looking to grow.

Mr Lowcock adds, however, that “not all small cap companies are growth companies”. He says: “Some are niche players and may stay that way, while others could be ageing businesses which have shrunk over time.”

In terms of funds, Mr Lowcock says funds investing in small companies do also hold shares in other companies that are in the FTSE 250 or even the FTSE 100, maybe from a long holding history from when the business was smaller, or due to a desire for liquidity.

But liquidity is not wholly lacking from the large and diverse small cap arena, Mr Hermon adds.

He said: “The common perception is that all small caps are illiquid and risky, but this is a simple generalisation.”

He also notes small caps have their own peculiarities that differ from their larger brethren.

“Small caps are usually more sensitive to economic conditions, performing better when the economy is stronger and weaker in a downturn.”

Generally, small caps are likely to perform well when the economic cycle is in the recovery and expansion phase when investors are more inclined to take on more risk.

Mr Hermon says these conditions are also true when merger and acquisition activity increases. M&A is a key driver of small cap performance as they often become purchase targets for larger companies.

“Conversely, during times of economic contraction when investors become more risk averse and the ‘flight to safety’ leads them to ‘safe havens’ such as government bonds and gold, and M&A dries up, riskier small caps are less loved.”

Mr Hermon points to a recent Goldman Sachs research report that looked at the use of volatility as an indicator of small cap returns, analysing changes in the volatility index (Vix) against the annualised relative performance of US small caps versus the S&P 500.

Mr Hermon said: “The report suggests that small caps outperformed significantly following the sharpest declines in the Vix.