Advantages and disadvantages of US small-caps

According to respondents to this guide, apart from a lower dividend yield as many smaller stocks are growth-focused instead of income-generating, key concerns include lower liquidity, less analyst coverage and greater risk on the downside with small-cap companies.

Jenny Jones, head of US small and mid-cap equities for Schroders, says the “primary disadvantage” of investing in small cap compared with large cap is the lower levels of liquidity and higher volatility than large cap.

Extrapolating returns back from the period January 1979 to March 2016, the standard deviation of returns for the Russell 2500 is 18.18 per cent, she said.

For the S&P 500 index of large-cap stocks, the standard deviation is 15.08 per cent. “Small to mid-cap as an asset class has more than 300 basis points higher standard deviation so this is a riskier asset class”, she says.

The lower analyst coverage actually creates an opportunity as it is possible to learn things about a company which are not broadly known Jenny Jones

However, for a UK investor, small in the US does not necessarily mean the same as small in the UK.

Some US small and mid-caps are equal in size to some UK large-cap companies, as Darius McDermott, managing director of Chelsea Financial Services, has pointed out.

He says this could be both an advantage - in terms of better liquidity - and a disadvantage in that underlying holdings in US small cap funds “may not be the really small companies you think you are getting”.

Policy matters

There are also concerns the US smaller-cap sector is more volatile, reacting more strongly to policy decisions made by the US Federal Reserve or political pronouncements, for example.

Robert Siddles, manager of the £159m Jupiter US Smaller Companies trust, explains: “US small caps are higher beta than large caps, as their daily reaction to events will generally be greater.

“The main driver to their performance as a sector is sentiment to the economy: they outperform when economic prospects are viewed to be improving. What the Fed says or does is only part of investors’ views as they may interpret the Fed according to their mood.”

He says historically, US small caps have tended to do well in the months after the first Fed rate rise and better after the second, as it usually means the economy is doing well.

“Once the Fed slams on the brakes because inflation is too high”, Mr Siddles adds, “a recession becomes more likely and equities, including small-caps, turn down.”

The view of Francis Gannon, co-chief investment officer of The Royce Funds, is the correlation between economic policy developments and the performance of small caps is more sector than market-cap specific.

Mr Gannon says: “It is hard to generalise as each company is different but I think the correlation tends to be more pronounced by industry and sector.

“More interest rate-sensitive industries are naturally more susceptible to the Fed’s policy decisions, for example.

“Within those industries, we do tend to see more volatility in small caps than in large caps, but only over the short term. And we’re always trying to use those short bursts of volatilty to our advantage.”

Analyst coverage

Another potential disadvantage is the lack of research on smaller companies compared with the number of analysts researching large-cap companies.

With fewer analysts covering smaller to mid cap corporates, a lack of information could lead to investors having a lack of confidence.

However, Mr Siddles disagrees.

He says: “The lack of liquidity and research coverage are often cited as disadvantages but they are just part of the job, which is why you employ a specialist manager.

“From the investor’s point of view, the lack of liquidity and research coverage are two great advantages of small cap investing.

“For a value investor looking for out-of-favour stocks, lack of liquidity in small cap means they are apt to get much cheaper than they would if they were more liquid, giving the opportunity for a bigger recover.

“Lack of coverage means you are much more likely to discover neglected shares which may outperform over the long run.”

The size and diversity of the US economy means there are always pockets of opportunitiy in small and mid-cap markets Francis Gannon

Ms Jones believes the lack of analyst coverage is not a disadvantage but an advantage.

She says: “The lower analyst coverage actually creates an opportunity as it is possible to learn things about a company which are not broadly known and develop non-consensus views on a stock.

“Purely following consensus makes it difficult to out-perform; the opportunity to develop non-consensus views is important to generating excess return.”

Chelsea Financial Services’ Mr McDermott backs up this view, saying: “The track record of active managers consistently outperforming the index seems to be better in small-cap than in large cap.”

When one strips out the passive funds from the Investment Association (IA) sectors, Mr McDermott says small cap managers can find the winners more easily as it is a less efficient market.

He explains: “It is a much less efficient market as small companies tend only to have two or three regional analysts covering them while Apple, for example, has more than 50.

“I think this is an advantage for companies who operate in this space, rather than a disadvantage. It means they are one of few looking for the investment opportunities so can really add some value.”

Size of the market

For Mr Siddles, one main advantage - apart from the lack of analyst coverage - is the “huge universe in which to hunt”. He comments there are at least 2,000 stocks in the US mid-and small-cap market, compared with 680 in Europe and 250 in the UK.

This is a view shared by The Royce Funds’ Mr Gannon: “The size and diversity of the US economy, as well as its global reach, means there are always pockets of opportunitiy in small and mid-cap markets.”

The Russell indices - which includes the Russell 2000 - began life in 1984, when the firm launched a family of US indices to cover a wider range of stocks across America.

In June 1990, Russell launched its 2500 index, which comprises small- to mid-cap US companies, weighted by market capitalisation. It currently has 2,454 companies on the index.

It boasts names potentially familiar to UK investors, such as Abercrombie & Fitch, Advent Software, Barnes & Noble, Evercore Partners, and Krispy Kreme Donuts.

With many of these stocks being cash-rich and with solid management teams, Cormac Weldon, manager of the £64m Artemis US Smaller Companies Fund, says investors should not need to “run into liquidity” problems.

He comments: “It is our experience investors can buy small and mid-caps in the US without running into any liquidity problems.

“But defining small-cap correctly is important. Our fund invests in companies whose market value is below US$10bn (£7.55bn). At the end of May this year, the average market cap of our holdings was US$4.7bn (£3.55bn).

“In US terms, many of these are mid-caps and liquidity is not a problem.”

Macro trends

US small and mid-cap funds have also been recent beneficiaries of a stronger upturn in the US economy, according to Rob Gleeson, head of FE Research.

He says although the smaller caps are more dependent on the US economy and there is a risk premium attached to smaller and mid-caps because they are “less robust” than large-caps, their size can also “give them an edge” over blue-chips.

Mr Gleeson explains: “What gives them an edge over large-caps is the more domestic focus. They tend to have greater dependence on the US economy and as the US economy has been one of the best performing, a greater focus on this market has been beneficial.”