The fund, run by small cap specialist Charles Montanaro, has returned 97.05 per cent since launch in 2007 while the average IMA UK Equity Income fund has returned only 44.03 per cent.
However, the Ireland-domiciled portfolio has flown under the radar of most investors because it is not included in the IMA sectors, which will shortly change.
The fund has absolutely no fees, which will not change until it reaches £100m, Charles Montanaro explains. It is currently £71m. Once it reaches £100m in size, investors will be charged 75 basis points.
“The fund has the best track record of all of our products, but we have never marketed it,” he said.
The chief reason for this is that the fund contains a lot of the manager’s own money and that of his family and friends, and has been run primarily for their benefit.
However, the fund is being opened up to retail investors and is currently available directly through the fund house or through certain IFA-only platforms: Nucleus, Cofunds, Novia and Raymond James.
The fund is in the process of being added to certain retail-friendly platforms, too.
It currently appears in the offshore performance tables; however FE data shows it would be one of the top performers in the IMA sector.
Over five years it would be third, beaten by only Unicorn UK Income and PFS Chelverton UK Equity Income, with which it shares a small cap focus.
Performance of funds vs sector over 5yrs
Source: FE Analytics
Over three years it slips into the second quartile but over a seven-year period, which includes a full cycle – i.e. the market fall in 2007 and 2008 – the fund does even better, being beaten by only Unicorn UK Income.
Performance of funds vs sector since launch
Source: FE Analytics
Montanaro explains that his is a quality growth strategy, meaning that he expects to outperform in normal and falling markets but potentially underperform in cyclical “dash for trash” rallies such as the one seen last year.
“I look for high-quality businesses operating in growth markets with strong management teams and the prospect of growth of both dividends and also earnings,” he said.
“The key point about our income fund is that investors do not need to sacrifice quality and a low-risk investment approach for yield.”
“We do not invest in areas of the stock market that are opaque or linked to a commodity price that we cannot forecast (such as gold and metals).”
“These companies are not in control of their own destiny and are hard to value. We do not invest in loss-making companies.”
“We will invest in companies that provide services to the oil industry but not to exploration and production companies.”
“Our sole exposure to this sector in the income fund is a Norwegian seismic testing company, TGS Nopec.”
“We do not invest in loss-making companies, which rules out biotechnology. We also avoid banks as they are opaque – no one really knows what their loan book looks like – which makes them hard to value.”
“This applies to commodity-related companies too. We also are wary of 'high technology' companies such as semi-conductors, partly due to a preference for businesses that are simple to understand but also due to technological risk (an existing technology can become obsolete due to a new technology that may not even exist today).”
Value companies outperformed in 2013 as investors moved into cyclical sectors that had been avoided in the years of crisis. Montanaro says that the last time this happened was in 2003, when his other funds underperformed for the same reason.
“Buying blue chip small caps, you should outperform in down markets and normal markets and in one out of 10 abnormal markets you might underperform,” he said.
“People were buying low-quality companies last year in expectation of an economic recovery.”
The fund previously had a high weighting to Europe, which exacerbated this behaviour.
It retained a 60 per cent weighting to the UK before the end of 2013 when it shifted to its current 80 per cent to bring it in line with IMA sector restrictions.
Although the fund’s returns in 2013 and 2009, the years of cyclical recovery, are only second quartile in comparison with its offshore European peers, they would still put it in the top quartile of the IMA UK Equity Income sector.
Montanaro says that he expects a more “normal” market this year, which would be more conducive to his style.
“After particularly strong returns since 2009, investors should expect more normal returns this year, possibly in the range of 10 to 15 per cent,” he said.
“Last year saw a marked re-rating of the stock market, which is unlikely to repeat in 2014.”
“So returns are likely to be based almost exclusively on growth in earnings. Many 'value' companies performed well last year in the expectation that they would see a strong recovery in earnings which has yet to materialise.”
“Therefore I would expect investors to focus on higher quality companies where the certainty of improving earnings is greater.”
“Investors seem to have forgotten that stock markets can go down as well as up, so a correction of 5 to 10 per cent some time this year would be a healthy reminder.”
“Global economies are recovering, which should lead to rising interest rates over the next few years, which will be bad for bonds.”
“Equities should remain the most attractive asset class. I would expect interest in small caps to increase and for positive absolute returns in 2014.”
“However, this bull market is getting long in the tooth and investors should be increasingly careful as we move into 2015.”
Montanaro the firm exclusively runs small cap portfolios and is institutional in focus, which explains its relatively low profile.
The soft-closed Montanaro European Smaller Companies fund is top-quartile over 10 years, according to FE data.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
The closed-ended version of the fund was recently tipped by Cantor Fitzgerald analysts as one to buy at this point in the cycle while growth is out of fashion.
Montanaro says his company’s exclusive focus on smaller companies gives it an edge over its competitors in terms of research resources.
“You must meet the management of companies in small caps so you need a high level of resources,” he said.
“The concern we have got is the rush for income seems to be indiscriminate and the level of due diligence might not be as much as it should be.”
