The FTSE Small Cap index experienced a muted first half of 2018, with a return marginally into positive territory at 0.1% to the end of June. This trailed the larger end of the market as the FTSE 100 posted – an albeit still subdued – 1.7% total return over the same period.
However, the outcome was better for investors in active UK smaller companies funds, which as a collective comfortably outperformed the small-cap index. The average fund in the Morningstar UK Small-Cap Equity Category returned 4.7% in the first six months of the year, while just four funds in the UK Smaller Companies IA Sector underperformed the index.
This strong relative performance is a continuation from last year, when the category average fund outperformed the index by more than 10 percentage points in 2017.
Perhaps linked to this, investor flows into active UK small-cap funds in 2018 have continued to be resilient. Despite the uncertainties surrounding the domestic economy, positive small cap sentiment has been bucking the wider trend of significant outflows from UK All Companies funds.
According to Morningstar data, estimated net inflows into UK small-cap funds stood at over £400 million in the first five months of the year, despite net outflows totalling several billions from UK funds focusing on the larger end of the market.
Technology was an important contributor to active small-cap fund performance in the first half of 2018, and the average fund’s overweight to the sector certainly helped active returns, but stock selection within that part of the market also contributed strongly. Indeed, attribution analysis indicates that, with overall sector allocation only mildly positive for the average fund, strong stock selection across a range of sectors has driven small-cap fund performance over the first half of the year.
AIM Stocks Outperform Larger Counterparts
AIM, the junior market of the London Stock Exchange, outperformed the FTSE Small Cap index in the first six months of 2018, and some of the significant contributors to active performance in the period – the likes of Blue Prism Group (PRSM) and FeverTree Drinks (FEVR) – are listed there.
AIM’s representation in funds has risen over recent years as fund managers have increasingly found strong investment opportunities in that market and have often broadened their remits to allow a larger proportion of their assets to be invested in AIM-listed stocks. Nonetheless, being selective about one’s stock picks remains highly important in that less regulated market, one that is viewed as higher risk by many investors.
More generally, given the greater business risk of investing in smaller companies compared to large blue-chips, avoiding stock blow-ups – not just in AIM but across the small-cap investable universe – plays an important role in a small-cap fund manager’s alpha generation capability. The demise earlier this year of Conviviality Retail, which was held by a number of funds in the category, serves as a reminder of the downside risk.
On the other hand, small-cap stocks tend to be covered less by the wider analyst community than those at the larger end of the market, thus allowing greater opportunity for active fund managers to unearth undervalued or underappreciated companies with the potential to provide significant positive returns over the initial investment.
Funds to Access Small Cap Stocks
Old Mutual UK Smaller Companies Focus is managed by Nick Williamson, who took over the lead in January 2016. Although his portfolio management experience is relatively limited, his overall investment experience is much longer, and he enjoys the support of a highly regarded team. There are some differences between this fund and the Old Mutual UK Smaller Companies fund managed by team head Dan Nickols.
For example, the relatively limited assets under management has allowed Williamson to add some interesting micro-cap stocks where he sees significant potential upside. Over his tenure so far, he has demonstrated diligent implementation of the house approach, and the fund earns a Morningstar Analyst Rating of Bronze.
SLI UK Smaller Companies holds a Morningstar Analyst Rating of Silver. Fund manager Harry Nimmo is a highly experienced UK small-cap investor who has managed money in the same style through a variety of market cycles. Nimmo draws on a proprietary stock-selection screen, followed up by qualitative fundamental analysis that includes assessment of a company’s key growth drivers.
The portfolio consistently displays a very strong growth bias, which can cause the fund to look out of step with peers and the index at times, but over the long term it has provided very strong performance for investors.
TB Amati UK Smaller Companies is managed by an experienced team of portfolio managers led by Paul Jourdan. They seek to invest in companies with a clear competitive advantage, sustainable growth and ability to finance that growth, and high returns on cash invested. Longer-term sustainable growth ideas are the primary focus, but the team will also invest in more-cyclical stocks where appropriate while seeking to maintain the emphasis on quality.
AIM has typically been a meaningful source of ideas given the team manages AIM VCTs as well, but the managers also look to diversify by market-cap and will hold stocks up into the FTSE 250. The fund holds a Morningstar Analyst Rating of Bronze.
A version of this article appeared in Money Marketing magazine
