So far in 2016 UK markets (particularly the FTSE 100) have been battling worries surrounding China, central bank policies and oil prices. In spite of the market turbulence at the start of the year, the UK Smaller Companies space has been largely resilient to any market woes. The sector typically tends to overcome any macro volatility and see stronger returns than the average UK All Companies fund.
During April, UK Small Companies saw net retail sales of £17.5m – a sight drop from £20m the month before. UK Smaller Companies funds were more popular in Isa sales, with net sales of £23.4m across the five platforms the Investment Association uses for sales figures (Cofunds, Fidelity, Hargreaves Lansdown, Old Mutual Wealth and Transact).
During 2015, the FTSE 100 fell by 1.3 per cent, while the FTSE Small Cap ex IT index rose 3 per cent.
The IA UK Smaller Companies sector also generated an average return of 14.9 per cent in 2015 as a whole, while the UK All Companies sector saw an average 4.9 per cent return, according to FE data.
Volatility
One reason UK Smaller Companies may attract fewer investors than the UK Equity Income space, for example, may be due to volatility. The IA stipulates that funds must invest at least 80 per cent of their assets in UK equities of companies that form the bottom 10 per cent of the market by capitalisation.
This end of the market can see much more volatility than you typically get from larger companies, but at the same time it can also have much greater room for growth compared with large-cap companies. As such, due to the typically more volatile attitude of the funds, investors can largely expect to be paid on taking that risk.
Table 1 shows the top 10 performing unit trusts and investment trusts in the IA and AIC’s Smaller Companies sectors over five years.
While performance across the sector over one year is not particularly solid, its five-year performance tells a much different story. The top-performing unit trust is the R&M UK Equity Smaller Companies fund, managed by Philip Rodrigs.
The £666.6m fund saw a return of £2,421 over the five-year period based on an initial £1,000 investment — 19.4 per cent annually. The fund is largely invested in industrials (25.3 per cent) and consumer services (16.5 per cent). It aims to invest in UK equities that reside in the bottom 10 per cent of the UK stock market in terms of market capitalisation.
The top-performing investment trust saw even higher returns over five years. The Chelverton Growth trust saw returns of £2,735 — 22.3 per cent annually — and has also seen strong returns over the past 12 months, returning £1,634 on an initial £1,000.
The trust, which is run by David Taylor and David Horner, interestingly invests only in Aim stocks (currently 60.3 per cent of its asset allocation) or Official List companies.
It does not invest in any listed investment companies or investment trusts. The trust also has a market cap of £50m for investments and aims to invest purely in those its managers believe to be at a point of change.
Annual figures
The Table also shows annualised discrete data for the past five years. It is clear the years between 2012 and 2014 saw huge returns for UK small-cap funds, particularly 2012-13 for the Fidelity UK Smaller Companies fund, managed by Jonathan Winton and Alex Wright, which saw a 61.3 per cent return over the year.
On the investment trust side, Gresham House Strategic saw a massive return of 80.3 per cent in the same year.
The success of UK small-cap funds has moved some fund groups — including Liontrust and Marlborough — to launch micro-cap funds, reaching the smaller end of the market in companies that tend to have a market cap of £150m and below.
The year ahead remains uncertain for the UK in general, particularly following the EU referendum and its inevitable fallout. Speculation will now surround when the Bank of England is going to raise interest rates and by how much.
But should small-cap funds continue to remain strong amid market concerns, it could be a better year to be invested in them than in large-caps.
FIVE QUESTIONS TO ASK
1. Should I use an investment trust or unit trust?
Both carry separate risks, but there is no right or wrong answer. It all depends on the individual investor. Typically, investment trusts outperform unit trusts over the long term, but investment trusts can carry more risk and liquidity issues.
2. What size market cap do they invest in?
According to IA stipulations, UK Smaller Companies funds must invest in the bottom 10 per cent of the market. A lot of funds will use Aim-listed companies and others will use unlisted companies, so check the fund’s asset allocation before investing.
3. How much risk do they carry?
It all depends on a fund’s asset allocation. Generally speaking, small-cap funds will experience more volatility than their large-cap counterparts.
4. Is an active fund better than a passive fund?
It is the age-old debate of active versus passive management, but it all depends on individual client needs and their suitabilities. They are both suited to the UK market, but cost and performance can vary hugely.
5. Do the funds purely invest in the UK?
Not necessarily. While 80 per cent of the fund must be invested in UK securities, there are still many funds that will hold varying proportions of the remaining 20 per cent in other countries. There are also some companies that, while listed in the UK, have a very global exposure.
