The obvious risk asset for investors is equities, and for the especially adventurous emerging markets and small caps are popular options. Both sectors have been significantly more volatile than large cap developed market equities and bonds over the long term, but returns have been much, much higher.
Performance of sectors over 15yrs
Source: FE Analytics
Past performance, of course, is not a guide to the future, and there have been sustained periods where both UK small caps and emerging markets have underperformed. In the mid-to-late 1990s, for example, the Asia crisis contributed to a terrible period of performance for emerging markets.
UK smaller companies are dependent on the domestic economy and emerging market countries such as China, Brazil and India are affected by factors such as the strength of the US dollar and the performance of commodities.
Even when you’re investing over the long term, diversification is important. This, according to Steven Richards at Thesis, makes a strong case for global smaller companies fund if you’re investing for the long term. He argues these funds eliminate regional risk, and also allow investors to benefit from the growth potential of smaller companies.
“I’m a big believer in small cap for the obvious long-term outperformance reasons, and I have a quarter of my pension in global small cap funds as a result,” said the manager, who also has a major stake in global small caps in client portfolios.
“Small caps are believed to correlate much more with domestic fortunes whilst large cap companies are more beholden to the global economic cycle.”
“Because regional economies move at different paces to each other, this should therefore be ideal for the global small cap manager to dynamically allocate between and capture performance at different points from different markets.”
There is a big caveat however: Richards points out that small caps require a huge amount of research even on a regional basis, making a global mandate very difficult to manage.
He adds that most are heavily focused on the US and have very little in emerging markets and Asia, meaning that in reality they are US small cap funds with a weighting to the UK and in some cases Europe.
“I am disappointed that the managers I know don’t have greater weightings to emerging market, European or Japanese small caps,” he said.
“I therefore am forced to complement my global small cap funds with specific emerging markets and European small cap funds.”
Stevens currently holds Douglas Brodie’s small-cap focused Baillie Gifford Global Discovery fund, Harry Nimmo’s Standard Life Global Smaller Companies fund and the team-managed Invesco Perpetual Global Smaller Companies fund.
To compensate for the issues raised above, he also holds the iShares MSCI EM Small Cap ETF and the F&C European Smaller Companies portfolio as well.
FE Trustnet will review all global small cap funds available to UK investors in an article next week.
Gary Potter (pictured), co-head of multi-manager at F&C, agrees that there are fundamental weaknesses in most global small cap funds. However, unlike Richards, he prefers to construct his regional small cap allocation from scratch. “We’ve never bought a global small cap and probably never will,” he said.
“When it comes to global investing, you need a rigid regional allocation process. It’s very difficult to be an expert in every area, and we’ve found on average that we’re able to get a 10 per cent better return from experts in one field and then do the asset allocation ourselves.”
Potter currently holds F&C European Smaller Companies and Fidelity UK Smaller Companies funds in his £57m F&C MM Lifestyle Growth portfolio.
He does believe global small cap funds are a good option for investors looking for a one-stop shop however, adding that being diversified away from the UK is a particularly good idea at the moment given the threat of an impending general election.
“This is a risk-off asset whatever anyone says. Small caps are more affected by global growth, so it’s naturally a more vibrant area of the market,” he continued.
“We believe the world is okay from a growth point of view, and so buying the dips this year has made sense to us. It’s certainly not an area we think investors should be selling, and if anything we’ve been adding to some small-cap managers and some managers with a decent weighting to them.”
Both Stevens and Potter say the vastness of the global small cap market means boutique firms tend to avoid launching funds in this area. There is one big exception, however.
The little-known £59m McInroy & Wood Smaller Companies portfolio is a standout performer in the IMA Global sector, achieving top-decile returns over five and 10-year periods. It is second quartile over one and three years.
Over the past decade the fund has returned a whopping 259.2 per cent, second only to Skagen KonTiki. The sector has returned 105.6 per cent over the period.
FE Alpha Manager Tim Wood doesn’t have a benchmark, though the MSCI ACWI Small Cap index is the most obvious comparison. FE only has data for the index going back to June 2007; since then, McInroy & Woodford Smaller Companies has outperformed with almost exactly the same volatility.
Performance of fund, sector and index since June 2007
Source: FE Analytics
Wood is very clearly benchmark unaware, with less than 30 per cent invested in the US. UK and continental Europe are his two biggest regional positions, though he has next to nothing in emerging markets.
For a small cap fund the portfolio is relatively concentrated, with almost a third of assets in the top 10. Major positions include US-listed Tractor Supply Group and FTSE 250 instrumentation company Spectris.
Unfortunately, the fund is only available on certain platforms, including Transact.
Like Potter, Saunderson House portfolio manager Ben Williams currently uses regional small cap managers. However, he says this could soon change.
“We haven’t got anything in that space at the moment – we allocate to funds by region at the moment though global is something we’re increasingly looking at,” he said.
“Depending on valuations and sentiment, global smaller companies are potentially an interesting asset class to invest in.”
He believes there are a handful of managers who have successfully translated their success in UK small caps into an attractive global strategy – namely Standard Life Global Smaller Companies and Baillie Gifford Global Discovery.
“These are two we’ll probably look at when valuations become more attractive,” Williams added.
FE Trustnet will review all global small cap funds available to UK investors in an article next week.