Though they delivered returns of close to 40 per cent in 2013 as a result of a strengthening economy, a growing appetite for risk and huge amounts of added liquidity flowing through markets thanks to central banks, UK small-caps had a largely disappointing 2014.
According to FE Analytics, IA UK Smaller Companies was the worst performing sector last year with a loss of 1.65 per cent, with certain funds – such as Standard Life UK Smaller Companies and Schroder UK Dynamic Smaller Companies – falling more than 8 per cent.
Performance of sector and index in 2014
Source: FE Analytics
A number of reasons have been given for those losses, such as profit taking from 2013’s gains, the prospect of higher interest rates and mass outflows from certain large-cap ‘tourist’ funds which were overweight the FTSE 250 and Small Cap indices to add alpha relative to the wider market.
Nevertheless, while money was pouring into the sector at the start of last year, even though the average fund gained 37.18 per cent in 2013, our most recent poll – in which 1,700 votes were counted – shows most investors are now bearish on smaller companies despite their lower valuations.
Therefore, have investors got their timing all wrong or are they right to avoid the sector for the time being?
There are certainly a number of experts who are cautious on smaller companies, including some who operate in the sector such as FE Alpha Manager Daniel Nickols, who runs the Old Mutual UK Smaller Companies fund.
He recently told FE Trustnet that investors should expect 2015 to be another difficult year for UK smaller companies funds as consensual levels of earnings growth may once again prove too high.
“2015 will, I think, be another tricky year for the UK market, but I do expect it to be an environment where positive total returns can be delivered,” Nickols said.
On top of that, a number of fund allocators think FE Trustnet readers are making a prudent decision.
Ben Willis, head of research at Whitechurch and member of the AFI panel, is maintaining his weighting to smaller companies funds within his higher risk client portfolios as he thinks they will deliver decent returns over the long term.
However, he fully understands why investors are reticent to up their exposure in the current climate.
“I think people see that 2014 was difficult, but you also have to take into account that they have delivered strong returns over the last few years,” Willis said.
Our data shows the IA UK Smaller Companies sector has delivered a stellar return of more than 200 per cent since the UK market bottomed in March 2009 after the financial crisis.
Performance of sector and index since Mar 2009
Source: FE Analytics
Willis continued: “I wouldn’t say they are massively expensive at the moment, more fair value, but we have had the re-rating and now we need the earnings growth to come through. At the same time there is a lot of uncertainty about. Volatility has come back and what gets hit the most during times of uncertainty? Higher risk assets like small caps.”
“All these are short-term concerns, but there is the election this year and also who knows what is on the horizon with interest rates, so there are a number of headwinds out there.”
However, Willis says it is too easy to just focus on an index level as there will undoubtedly be opportunities on a stock by stock basis.
He therefore recommends choosing a fund with a genuine multi-cap approach, whereby the manager has the flexibility to allocate to all parts of the UK market – be it small, mid or large caps – to find value.
His favourite offering in that space is George Godber and Georgina Hamilton’s CF Miton UK Value Opportunities fund, which he began buying in September last year after selling the Schroder UK Opportunities fund following Julie Dean’s departure.
CF Miton UK Value Opportunities – which was launched in March 2013 – has 20.1 per cent in the FSTE Small Cap, 24.5 per cent in the FTSE AIM, 36.4 per cent in the FTSE 250 and 8.3 per cent in the FTSE 100.
Godber and Hamilton have a clear-cut value approach to investing, by which they focus on companies which are out of favour with the wider market.
According to FE Analytics, it has been the third best performing fund in the highly competitive IA UK All Companies sector since its launch with returns of 31.62 per cent. As a point of comparison, the FTSE All Share has returned 8.23 per cent over that time.
Performance of fund versus sector and index since March 2013
Source: FE Analytics
While that is only a short track record, it does include the strongly rising market of 2013 and the far more difficult market of 2014.
CF Miton UK Value Opportunities has an ongoing charges figure (OCF) of 0.94 per cent.
Gordon Smith, fund analyst at Kilik & Co and a fellow member of the AFI, is more constructive on smaller companies, however.
He says investors are unlikely to ever time the market and while he expects a difficult period over the short term, investors with a five-year plus time horizon can afford to take risk with smaller companies at the moment.
“We are likely to have a period of heightened volatility in the UK and Europe, but providing you can withstand that, then over the longer term there is still definitely an investment case for adding to smaller companies, or certainly not being underweight them,” Smith said.
He says that for the 43 per cent who expect to add to UK smaller companies exposure, now may be a good time to look in the listed space as last years’ poor returns and falling appetite for risk has left investment trusts attractively valued.
Data from the AIC shows that out of the 13 trusts in the IT UK Smaller Companies sector, eight of them are currently trading on wider discounts than their one-year average, with the likes of Henderson Smaller Companies, Dunedin Smaller Companies and Montanaro UK Smaller Companies all on double-digit discounts.