Lack of US small-cap funds blamed on low demand

The Investment Association’s North American Smaller Companies sector has just 13 funds from which investors can choose, compared with 119 funds in the Investment Association (IA) North America sector.

Despite the richness and maturity of the US stock market, most IA North American funds focus on just the largest listed companies in America, and not on smaller or mid-cap stocks.

Moreover, many funds in the sector do not even look at the whole continent, and ignore strongly performing companies from Canada and Mexico in favour of picking stocks only from the S&P 500 index of the largest American companies by market capitalisation.

Part of the reason there is not a lot of choice for investors considering investing in US small-cap funds may be due to performance trends between the two sectors.

Over the past three years, according to data from FE Trustnet, the IA North America sector average has gained a near-12 percentage points lead on the IA North American Smaller Companies sector.

The popularity of US smaller and mid-cap funds is less among UK retail investors, data from the Investment Association has found.

Over the past year, North America funds have seen inflows in terms of millions of pounds coming into the sector, with January 2016 net retail sales reaching a one-year high, compared with the outflows seen in December 2016.

Conversely, US small and mid-cap funds saw consistent outflows over the past year, only rebounding slightly in April 2016 with a net positive flow of investor money into the sector, as the table shows.

Table: Popularity of US equity fund sectors, based on fund sales

Source: Investment Association

While fund launches in the larger-cap sector continue - a recent example being the new Standard Life Investments’ American Equity Income fund, managed by Scott Eun and Warren Gibbon - there have been few developments in the small-cap arena.

Income

Another reason for US small and mid-cap funds failing to prove as popular as the larger-cap rivals could be the current search for income among investors.

This is the view of Robert Siddles, manager of the Jupiter US Smaller Companies trust, who comments: “US small cap is considered niche, particularly as US small-caps do not generally have a yield, and a lot of emphasis is on sectors which generate an income, particularly for retirees in a low interest-rate environment.

“Dividends are less important in the US, and the yield on the index is only just about 1 per cent. Most of this comes from sectors with more limited capital appreciation potential.”

According to Cormac Weldon, manager of the £64m Artemis US Smaller Companies fund, the familiarity of big-name brands may be another factor.

It is important to remember US small caps could actually be the same size as UK mid-and large-caps, so liquidity is arguably less of an issue in the US Darius McDermott

“It may be this familiarity helps to frame their views of the US as a market of global giants. But there is more depth and diversity to the US than some investors might imagine.”

This is also the view of Jenny Jones, head of US small and mid-cap equities for Schroders. She says: “We think the primary reason for the small number of US small-cap funds in the IA universe is investors outside the US tend to focus on the S&P500.

“Even within the US, the first equity investment tends to be in large-cap, and the second investment is in small, small-medium or mid.”

Ms Jones adds: “If US investors choose to invest in small-cap outside of the home market, it tends to be a global small-cap fund, rather than a single-market fund. I suspect this may be true of investors generally.”

Moreover, many chief investment officers may also have not had the same direct experience of investing in the US in the way they have experience of investing in Europe, for example.

Mr Weldon explains: “The result is many chief investment officers who are happy investing in smaller companies in Europe may be more cautious about investing in smaller companies in the US.”

Francis Gannon, co-chief investment officer of small-cap specialist The Royce Funds, agrees to an extent, saying the popularity of mutual funds in the US only really “grew with the advent of IRAs, 401Ks and other self-directed retirement plans.

“This created an opportunity for small-cap specialists to gain a foothold. As increasing numbers of US investors began to understand the attractions of small-cap stocks, the number of products took off and hopefully non-US investors will see similar things in the years ahead.”

The UK or ‘domestic’ bias could also be a factor in the lack of popularity of US small-cap funds; there is just not much demand for small-cap funds among UK investors.

It is just not “fashionable”, adds Mr Siddles: “The US has been unfashionable for a very long time”, he says.

Matt Axline, US-based portfolio manager of the Allianz Global Investors’ Global Small Caps team, explains: “Several UK private client managers have grown up from traditional stockbroking roots, and have maintained a large overweight to UK equities, including UK small-cap funds.

“As these investors adopt a more sophisticated global view, however, we expect exposure to global small caps - and US small caps, for that matter - to increase.”

Rob Gleeson, head of Financial Express (FE) Research, agrees: “The average UK investor has a bias to the UK markets, so the amount allocated to the US in an average portfolio is quite small.

“It might be the investor allocates to a global equity fund, gaining some US exposure that way, or maybe has a small portion in US equities, but not enough to split between large and small cap.

“Therefore, a generalist fund is usually the popular choice. With such limited demand, it is no surprise supply is also limited.”

Darius McDermott, managing director of Chelsea Financial Services, comments: “Asset managers prefer to launch products where they can gather a large amount of assets and deliver attractive economies [of scale].

“This lends itself to large-cap where the liquidity is better and so capacity is not an issue.”

Currency could also play a part, as Mr Siddles explains: “Historically, at least until the great recession, UK investors suffered from the weakness in the dollar.

“Whenever the market was strong, the dollar would be weak, and vice versa. There was a perception it was difficult to make money from US equities generally.”

But UK investors might simply need more education about the option of small-caps, Mr McDermott says.

He comments: “UK investors do like UK smaller companies, so it is not as if investing in smaller-caps is a complete no-no. Perhaps they just don’t really know it is an option for the US.

“From a UK perspective, it is important to remember US small caps could actually be the same size as UK mid-and large-caps, so liquidity is arguably less of an issue in the US.”