Some argue that investors should hedge their bets by holding a broader range of small companies to insulate themselves from the blow-ups that inevitably result in the sector.
Others argue a relatively concentrated number of holdings will result in better returns over the long run.
According to the most recent FE Trustnet research, the there is no correlation between the concentrated nature of the portfolio and its success, implying superior returns come down to superior manager skill rather than picking the right strategy.
Some of the highest-conviction funds in the sector – such as the SF Webb Capital Smaller Companies Growth and Premier ConBrio UK Smaller Companies fund – have underperformed considerably over the last five years, but funds like the Discretionary UT Management Discretionary fund, which holds 54.81 per cent in its top holdings and the Unicorn UK Smaller Companies fund, which has 41.3 per cent, have both delivered top-quartile returns over the period.
Source: FE Analytics
The four FE Crown rated Discretionary fund, managed by FE Alpha Manager Simon Knott, though highly concentrated has been one of the best-performing funds in the IMA UK Smaller Companies sector over the last 5 years.
Over that time, the fund made 310.61 per cent while the sector gained 218.11. The fund has also eclipsed its benchmark, the FTSE Small Cap ex IT index, which made 228.75 per cent.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The bulk of its outperformance over the last five years came in the bull market of 2013, when the portfolio picked up 44.73 per cent.
However, it also beat the sector and index in the down markets of 2011, falling just 2.37 per cent while the index lost 15 per cent, according to FE Analytics.
However, unlike highly-concentrated funds in the IMA UK Equity Income sector, this portfolio does not aim to protect on the downside and indeed proved it can be volatile in the crisis year of 2008.
The Discretionary fund lost an eye-watering 50.64 per cent, falling slightly farther than the index which was down 48.32 per cent and the sector, which lost 40.54 per cent.
Its largest holding is the Rights & Issues Investment Trust, which makes up 8.61 per cent of the fund alone.
The smallest holding in the top-10, packaging company Macfarlane Group, makes up 4.05 per cent of the fund.
At the other end of the spectrum, stalwart smaller companies investor Giles Hargreave has been able to beat his peers, and the market, with just over 10 per cent invested in the top 10 holdings of his Marlborough UK Micro Cap Growth and Marlborough Special Situations funds.
Source: FE Analytics
Over the last five years, the Marlborough UK Micro Cap Growth fund has picked up 293.08 per cent, while Hargreave’s flagship Marlborough Special Situations portfolio gained 253.50 per cent. Both performance figures place the funds in the top-quartile of the IMA UK Smaller Companies sector, which gained 218.11 per cent.
Performance of funds vs sector over 5yrs
Source: FE Analytics
As a general rule, Hargreave doesn’t hold more than 2 per cent in any given holding in order to reduce the impact of a stock blowing up, which he says happens as part of the nature of investing in small businesses.
Currently, Hargreave’s largest holding in the five FE Crown rated Marlborough UK Micro Cap Growth fund is Isle of Man based online payments company Optimal payments, at just 1.8 per cent.
The largest holding in the £814m Marlborough Special Situations fund is online trading company Plus500, which makes up 1.9 per cent of the portfolio.
However, a diverse portfolio of holdings doesn’t necessarily guarantee outperformance either. The two funds in the sector with the least concentration – the Dimensional UK Small Companies fund and the Lazard UK Smaller Companies portfolio – have both fallen delivered third-quartile returns relative to their peers over the last five years.
The Dimensional fund did outperform the sector over the period, but only slightly, with returns of 222.06 per cent. The Lazard portfolio trailed the sector by nearly 10 percentage points, picking up 209.99 per cent over the period.
Both funds have also trailed the sector over the last 12 months while markets have rallied, going to show a rising tide has not lifted all boats in the smaller companies sphere.
