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Nickols: Why UK small cap funds will keep underperforming

15 July 2014

The FE Alpha Manager’s Old Mutual UK Smaller Companies fund has been hit hard in the recent sell-off in the sector, and he doesn’t expect it to rebound any time soon.

By Alex Paget,

Senior Reporter, FE Trustnet

Concerns over interest rate movements, uncertainty in the wider UK equity market and “disorderly” technical selling will all contribute to a sustained period of small cap underperformance in the near-term, according to FE Alpha Manager Daniel Nickols.

ALT_TAG Having driven the UK equity market last year, small and medium sized companies have sold off significantly over recent months as investors have rotated their portfolios into the perceived safety of the FTSE 100’s mega cap names.

Nickols' £919.4m Old Mutual UK Smaller Companies fund has been hit hard by the correction and he doesn't expect the sector to rebound any time soon.

“Right now, I just don’t know how long this sell-off will last,” Nickols (pictured) said.

“I can’t get away from the fact that the sector and the fund have had a tough time of late. I don’t think smaller companies are expensive compared with the rest of the UK market, but I think the technical sell-off could continue over the near-term.”

According to FE Analytics, the FTSE Small Cap index and the average fund in the IMA UK Smaller Companies sector returned 32.77 per cent and 37.18 per cent respectively last year, while the FTSE 100 returned 18.66 per cent.

Performance of sector and indices in 2013


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Source: FE Analytics


Although smaller companies were the prime beneficiaries of last year’s rally, they have fallen considerably in 2014, as a number of industry experts had predicted.

Our data shows the sector has lost 2 per cent this year, while large caps have ground out a 1.96 per cent return.

Nickols says there are a number of reasons why this has been the case.

“Economic growth looks well balanced. On the face of it, we have a pretty benign backdrop for smaller companies, so why have they performed so poorly? I think their perceived sensitivity to interest rates is part of this and that is why sentiment towards smaller companies is fragile,” he said.

“The market is attempting to price in interest rate rises. I think the key risk people are concerned about is policy error, either that the authorities raise them too much and it chokes off growth and induces a recession, or that they tighten policy too slowly, causing the requirement for a far more aggressive hike at a later date.”

“There is a middle way of course, that economic growth isn’t too fast or too slow and that inflation remains subdued.”

However, the manager thinks these issues will continue to dog the market for some time to come.


“Right now, with that uncertainty, investors will remain cautious and adopt a wait-and-see approach,” he said.

“People were expecting earnings growth, not a further rating expansion, to bring the market forward. The earnings growth catalyst has been absent. I think it is unlikely that there will be any increased risk-taking, and sentiment, in the short-term at least, will remain uncertain as a result.”

Nickols took over the £919.4m Old Mutual UK Smaller Companies fund in January 2004.

It is the fifth best performing portfolio in the IMA UK Smaller Companies sector since then, with returns of 356.08 per cent, beating its benchmark – the Numis Smaller Companies ex ITs index – by more than 100 percentage points.

Performance of fund vs sector and index since Jan 2004

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Source: FE Analytics


The fund has beaten its benchmark in eight out of the last 10 calendar years, the exceptions being 2009 and 2012.

However, Nickols’ fund has struggled in the recent conditions, falling into the third quartile in 2014 with losses of more than 4 per cent.

Performance of fund vs sector and index in 2014

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Source: FE Analytics


He says this underperformance has been a result of stock-selection issues. The manager adds that his underweight position in the oil and gas sector, where there has been a large amount of M&A activity, has hurt his relative returns.

However, he claims that a more important factor has been the huge amount of technical selling in the small cap space.

“There are a range of market participants who wouldn’t be regarded as natural holders of UK small and mid caps, but have nonetheless added huge amounts of value by holding them over the last two to three years. These have been reducing their exposure to our area of the market,” he explained.


“I suspect it is due to the perceived sensitivity to interest rates or that they believe there are better opportunities elsewhere, but the compounding effect is that that exit has been done in a fairly disorderly fashion. In the near-term, we can’t quite work out how long that phenomenon will last.”

Several fund managers, such as Alex Wright, Ed Legget and Thomas Moore, have all been reducing their exposure to the lower areas of the FTSE All Share this year.

Nickols says his fund has been hit particularly hard by this indiscriminate selling because of its benchmark.

“This fund has always been benchmarked against the Numis Smaller Companies ex IT index,” he continued.

“That is an important distinction here, as the Numis index is rebased annually and seeks to take in the bottom 10 per cent of the UK’s fully quoted universe – therefore differing from the FTSE Small Cap.”

“The index takes in quite a material proportion of FTSE 250 companies and it is for that reason – and while I can’t prove it, I very much suspect it – that it has been very much in the firing line of the technical sell-off.”

Performance of indices in 2014

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Source: FE Analytics


Although the FE Alpha Manager is bearish over the short-term, he says there are a number of reasons why investors shouldn’t give up on the asset class.

He points to the surge of IPOs as a positive because they have refreshed a previously stagnant small cap market, as he and his peers now have more companies to choose from. He also thinks the recent sell-off has made valuations look more attractive.

“The UK market doesn’t look expensive – it’s not bargain basement, but still not expensive.”

“There was the perception that the valuations of smaller companies had become extended. However, after the relative weakness in the second quarter, they are now similarly valued to the wider UK market and earnings growth prospects are better.”

Nickols is maintaining a domestic bias within his fund, with overweight positions in support services, construction and household goods.

His top-10 holdings include Ashtead Group, Telecom Plus, Jupiter and Restaurant Group.

Old Mutual UK Smaller Companies has an ongoing charges figure (OCF) of 1.05 per cent.

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