The unforeseen global credit crunch and the returns that followed are a stark reminder of how investing in small cap funds can be a volatile affair. You could try t
o avoid the inevitable short-term losses by correctly timing your investments in-and-out of small-cap funds, but that’s a game that few experts even get right. You could even avoid small-cap funds altogether but there is still a compelling argument for investing in them. For one, academic research suggests they tend to outperform giant- and large-cap equities over the long-term. Second, because small caps have historically moved out of step with larger-cap stocks, they’re a good way to diversify a portfolio.
However, the investment experience in small-cap funds can be made a little less unnerving by picking a fund that has limited its downside risk better than most peers. But even in that instance, keep in mind that small caps only belong in a diversified portfolio and should supplement your larger-cap, core holdings. It’s also worth noting that because small caps have outperformed in recent years and market uncertainty has increased dramatically over the past six months, we don't advocate investing heavily in small caps at this point. For those looking to add to maintain their small-cap exposure as part of a long-term asset allocation program, however, we'll take a look today at lower-volatility small-cap offerings. Even with these, however, investors should note they are likely to be riskier than large-caps. We also think it’s probably best to delve into them slowly via pound-cost averaging to limit timing risk.
In this article, we’ll show you how to use the Morningstar Fund Screener to identify funds in the IMA Smaller Companies sector with lower-than-average Morningstar risk relative to their peer group. (Like standard deviation, one of the most-common gauges of risk, Morningstar Risk also measures volatility, but it places added emphasis on the downside). Such funds may stand a better chance of weathering small-cap downturns than other small-cap offerings.
The Screen
Using the fund screener, we’ll first set the Morningstar category to UK Small-cap equity. To help ensure we eliminate the riskier offerings, we’ll highlight the low and below average boxes on the Morningstar Risk bar, which is located under the tab labelled “Fund Performance and Risk”. Then, to keep costs in check, we’ll use the expense ratio bar, located under the next tab “Fund Fees and Purchase Details,” to limit our search to funds with a total expense ratio (TER) below two per cent and set the minimum initial purchase to £2000 to eliminate as many institutional share classes as possible.
Parsing The Results
Once we exclude institutional share classes from the list of results (those with TERs below one per cent), we are left with a total of fourteen funds: Aberforth UK Small Companies, Baillie Gifford British Smaller Companies, Credit Suisse Smaller Companies, Invesco Perpetual UK Smaller Companies, Investec UK Smaller Companies, L&G UK Smaller Companies Trust, Lazard UK Smaller Companies, Lincoln Opportunities, Marlborough UK Equity Growth, New Star Select Opportunities, Saracen Growth, Scottish Widows UK Smaller Companies, Standard Life UK Opportunities and SWIP UK Smaller Companies.
We’ll eliminate the Marlborough fund from the initial screen as it is not a pure small-cap play. The Marlborough offering is a bit quirky, with 29% of its assets in giant-cap companies and most of the rest in micro-caps. We’ll also drop the Lincoln Opportunities fund and Saracen as these funds have just moved to our UK Mid-Cap Equity category.
Keep in mind that while Morningstar Risk is good at what it does, it is a backwards looking, performance-based measure. With small caps enjoying a mostly-favourable environment in recent years, their risks may not be as clear. But we can look back to the early 2000s bear market for a gauge of how well small-cap funds might fare in a downturn. When the average fund in the Morningstar UK Small-cap Equity category suffered a 45% loss between February 2000 and March 2003, only the Aberforth, Baillie Gifford, Credit Suisse, Invesco Perpetual, Investec and Lazard funds managed to lose less than the category average during this tough period.
The New Star and Standard Life offerings are not included here because they were launched in June 2002 and November 2002 respectively. Much of the damage to small-cap stocks had already occurred and since early 2003, small-caps have had the benefit of tailwinds pushing them along. However, small-caps didn’t have it all their own way in 2007 and for the one year period to 31 December 2007, the New Star and Standard Life funds both lost more than their average category peer in the period.
The Aberforth fund held up well between 2000 and 2003 but underperformed its peers in 2007. Credit Suisse Smaller Companies isn’t likely to shoot the lights out but at just £40 million in assets, it’s a nimble fund that has managed its risk well thus far. The fund has been guided to beat its average category peer over the ten-, five-, and three-year periods while keeping volatility in check. The fund’s standard deviation is below the category average over the long- and medium term which characterises this offering as a steady small-cap fund. However, much of this performance cannot be attributed to the current manager James Chapman who took managment of the fund in June 2007 but he has been learning the ropes from previous manager Stuart Harris since June 2006.
Of course, you want to look at more than just a fund’s returns in one particular period. Make sure the long-term fundamentals underlying the fund are sound as well. The Baillie Gifford offering uses a bottom-up strategy which focuses on companies’ long-term prospects rather than quarterly earnings fluctuations. The fund seeks out those companies which have the ability to generate free cash flow and has plenty of working capital to keep the business running in adverse environments. The management’s process means the fund will be out of step with its rivals at times and can underperform its racier peers in the near-term, but we believe it’s also likely to lose less money in difficult times. The fund was a success under the management of Iain McCombie until he gave up the helm to Douglas Brodie in November 2007. Brodie has six years experience (all of which is at Baillie Gifford) and we believe the fund will continue in the same vein as it did under McCombie given Baillie Gifford’s team-oriented approach to investing.
Another manager we like in this arena is Richard Smith. He managed the Lazard UK Smaller companies fund before taking the reins at the Invesco Perpetual Smaller UK Smaller Companies fund in 2002. Smith manages downside risk by picking companies with strong fundamentals and taking a long-term view on stocks, thereby avoiding a lot of speculative fare. Like the Baillie Gifford fund, Invesco Perpetual’s fund may lag its peers in rallying bull markets, as we have seen since 2003. When the tide turns for the worse, these funds follow strategies that have historically navigated choppy waters better than most of their peers. We feel investors could do much worse than choose either the Baillie Gifford or Invesco Perpetual offerings. However, we feel the Invesco Perpetual offering just pips the Baillie Gifford fund given the recent manager change at the latter.
