Time to take a closer look at liquidity risks?

Moreover, investors in the space should be aware of the risks, particularly as there are signs the liquidity is drying up.

Sam Cosh, manager of the F&C European Small Cap fund, observes: “[In] small caps you get exposure to really interesting, niche businesses that can deliver good long-term growth aligned to great management, and you get access to mergers and acquisitions.

“There are lots of good reasons to be exposed to small companies and through time they have delivered better performances as a whole.

“But the big negative is liquidity, and people get scared when it dries up. The limited liquidity has a disproportionate effect on the movements of [the sector’s] markets.”

Richard Penny, manager of the L&G UK Alpha Trust, notes: “It’s always been an issue and it’s [something] that anybody getting involved with small companies has to take into account.”

He explains investors should only be concerned about liquidity at the Smid end of the market “if you want to get in and get out again very quickly”.

“But if you want to find some interesting companies and hold them for long periods of time and your clients understand that, it’s a very good place to be,” Mr Penny adds.

So is liquidity likely to be an issue for Smid investors in the near future?

Joanne Rands, co-manager of the Rathbone Recovery fund, points to a study by broker Liberum, which suggests liquidity across the UK equity market is around half pre-recession levels.

She says: “In keeping with perceived wisdom, liquidity reduces in line with market cap, so this liquidity drain will naturally be felt more at the lower end.

“This perhaps explains the current valuation discount seen at the bottom end of the small-cap index [below £320m market cap].”

But Ms Rands notes that the wider space retains its valuation premium to larger caps.

Mr Cosh says: “I do think the liquidity in the market has dried up a bit. I think that’s reflective of the general nervousness out there.

“If I put a 2 per cent position on to sell tomorrow, that would take me longer to do than it would have done this time last year, for example. So I suspect there is a bit of liquidity drying up, which is symptomatic of nervousness in the market.”

Mr Penny believes active stockpickers find inefficient stockmarkets more attractive in the long run. “Generally speaking, liquidity and valuation is fairly constant down to about £300m, then valuation and possibly liquidity and investor activity slides off from £300m.”

He adds that the “slope” is now steeper. “So if the valuation difference has got greater you can argue you’re getting better value. The question is when you will realise the upside from that value.

“A momentum player would say, ‘it’s a problem’, but the value investor would say, ‘there are more opportunities under £300m’.”

The tumultuousness in global equity markets since the start of the year may certainly have exacerbated any liquidity problems already in evidence in Smids.

Guy Anderson, manager of the Mercantile Investment Trust, points to the “patchy” liquidity of the past few weeks due to increased volatility as an opportunity.

“The way we look at it from the benefit of having a closed-ended vehicle is we look for opportunities that this throws up, because you can get a valuation disconnect where prices are moving around more than the fundamentals would dictate,” he explains.

“So anyone that’s taking a longer-term investment horizon should be able to look through such periods.

“I think investors at the moment are probably quite skittish and quite nervous, and anyone looking to make an investment – it doesn’t matter which market, whether it’s the UK or international – in equities should [consider] a longer-term time horizon.”

Ellie Duncan is deputy features editor at Investment Adviser