Should You Avoid UK Small Caps?

But surprisingly, even the worst small-cap performers have outshined their larger-cap peers - six of the 10 worst performing funds since the referendum have returned at least 7.75%. The 10 worst performing large cap focused UK funds, meanwhile, have only managed gains of 4% or less over the same period. 

Worst Performers Since the Brexit Vote (%)

So while UK equities continue to be one of the most underweighted asset classes and sentiment among UK investors remains near an all-time low, many people have been missing opportunities.

Thre three star-rated Kames UK Smaller Companies fund has returned 8.8% since the referendum result of June 24, 2019, putting it in the bottom of its peer group over that period. But the fund is up 18.3% year to date. 

The three-star rated Aviva Investors UK Smaller Companies fund has delivered a similar return over the three years since the UK voted to leave the EU but, with the exception of 2016, has beaten its benchmark in each year and is up 13.5% year to date. 

Dispelling a Myth

British blue chips have undeniably been aided by a weaker pound in recent years, which has helped to boost their bottom lines. But, contrary to popular belief, many smaller companies enjoy this tailwind as well. 

Guy Feld, co-manager of the four-star rated Marlborough UK Micro-Cap Growth fund, says the idea that all UK smaller companies are overwhelmingly focused on the domestic economy is a major misconception "If this was true, they all would have been hit hard because of the extended uncertainty around Brexit and the effect of that on the UK economy," he says.

His fund is one of the top performers in the UK Smaller Companies sector with a return of 13% since the referendum vote; almost half of the revenues of the companies in the portfolio (45%) come from overseas.

"Our portfolio is an example of the increasingly global nature of many small cap funds," Feld says. He points to Focusrite as one example of this; the company, which makes audio equipment, generates around 44% of its revenue in North America, 39% across Europe, Middle East and Africa, with the remaining 17% coming from the rest of the world. "It really is a worldwide business and there are many other smaller companies with a similarly global focus," he adds.

Value Still Out of Favour

But Brexit and the global enomic outlook give us only half of the picture. One thing is clear looking at the performance of UK funds: value is still out favour. 

Darius McDermott, director at Chelsea Financial Services, says this style of investing has been out of vogue for the best part of the past decade. With interest rates remaining stubbornly at rock-bottom, investors have turned to growth funds to deliver returns rather than taking contrarian bets. 

Andrew Hunt, manager of the one-star rated ASI UK Recovery Equity, which has returned just 2% since the referendum, says: “Investors are allocating aggressively towards growth and dumping volatile value stocks, regardless of price.”

He says that because investors are fed up of bonds yields being so low, they prefer to buy perceived safer assets in the equity space - so-called bond proxy stocks - defensive stocks that earn in foreign currency such as Diageo, Unilever and LSE and pay a reliable dividend. "But the downside is that they can be expensive," adds Hunt, who has been investing in the oil and gas sector, where he thinks other investors are under-exposed. 

The two-star rated Liontrust UK Equity Opportunities and one-star rated Quilter UK Equity Opportunities funds have also struggled in recent years - returning 2.2% and 3.5% respectively since the referendum. 

Mark Martin, manager of the Liontrust UK Opportunities fund, says poor performance has come partly from not owning many of these big defensive FTSE firms. Instead the fund has a higher weighting towards cyclical industrials and materials companies.

Smaller Companies, Big Returns

The five-star rated Jupiter UK Smaller Companies fund is the best performer in the small-cap space returning 17.3% - just 0.6 percentage points behind the five-star rated MI Cheverton UK Equity Growth, the best performer in the large-cap UK equity space.

“The UK's smaller companies have been surprisingly resilient and actively managed funds in this space even more so - this is a testament to the number of very good active fund managers we have. They have managed to add a lot of value in the face of adversity,” says Chelsea's McDermott. 

Top Performers Since the Brexit Vote (%)

James Baker, manager of Chelverton UK Equity Growth fund, says he sold a number of UK consumer and cyclical holdings following the Brexit referendum, while retaining a small number of favourite UK-orientated holdings.

“We focus more on structural growth businesses, overseas earners (mainly industrials) and those less tied to the economy. Given sterling weakness, that strategy has served the fund well over the past three years,” he explains. Cyclical stocks have, however, started to make their way back into the portfolio and Baker has recently invested in Severfield, a UK steel business. 

“While short-term trading at these companies is likely to continue to be impacted by the Brexit debate, we think this is more than reflected in their share prices and any political resolution could cause them to rally,” he adds. 

Two ethical funds are also among the top performers - the four-star rated ASI UK Responsible and five-star rated Liontrust UK Ethical funds have returned 11.3% and 13.1% respectively since the referendum. It seems that the shift to a digital economy, the drive to improve efficiency and the importance of improving quality of life have driven earnings.

Liontrust UK Ethical’s fund manager Peter Michaelis says: “Our themes are structural in nature and therefore less transient than cyclical drivers, which can change constantly." He says the fund has benefitted from holdings such as the Irish insulation group Kingspan, IT infrastructure business Softcat and Sophos, the computing security company.