The IA European Smaller Companies sector is now one of the most popular peer group in the Investment Association universe, according to data released this month for May, which showed it was the fifth best-selling with net sales of £124m.
Smaller companies are well-known for achieving particularly high returns when the economy is recovering and investment sentiment is bullish – two themes which characterise the eurozone at the moment thanks to quantitative easing (QE) and the recent Greek bailout deal.
It is understandable why the peer group has become increasingly popular over recent months as not only is the region, in general, one of the most in favour markets in the current environment, but European smaller companies have delivered stellar returns over the short term.
According to FE Analytics, since their lows following the global sell-off in September/October last year, the sector has returned 24.11 per cent beating the predominately large-cap IA Europe ex UK sector by more than 7 percentage points.
Performance of sectors and index since October 2014
Source: FE Analytics
As a point of comparison, the MSCI AC World index has returned 12.2 per cent over that time.
However, they are also renowned for being riskier and less predictable, which suggests that smaller companies fund are not well-suited to every investor.
Patrick Connolly, head of communications at Chase de Vere, says the financial advisory firm doesn’t have a specific allocation to European small-cap stocks in its client portfolios.
“We’ll have an allocation to European stocks and we will use multi-cap funds, so we will by default get some exposure to [the sector], but it’s not something we specifically look at because we know we’re going to get some exposure anyway to those through multi-cap funds,” he explained.
“We’re wary of being exposed globally to smaller companies. We understand the argument that, over the long term, smaller companies should outperform the larger ones but also with more risk and more volatility. It’s a case of getting the right balance for our clients rather than getting the best return at all costs.”
Apollo Multi-Asset manager Ryan Hughes says that, while he will be looking into European small-cap funds over the next few months after spying a handful of valuation anomalies, he rotated out of European small-cap funds and into large-caps after summer last year.
“We like Europe as a whole but we’ve been tending to play the QE-fuelled rally by moving a bit up the cap-scale and away from small-caps,” he said.
“We saw value in large-caps. We also thought there was likely to be some volatility coming so we wanted to be a little bit more defensive in that space at that particular time.”
“I think the reason why people are looking at [Europe] is trying to find ways of capitalising on what’s going on in Europe and the level of QE that was helping the market along.”
However, Francesco Conte, who manages four European smaller companies portfolios at JP Morgan Asset Management, says there are more substantial tailwinds for Europe at the moment than printing money.
One of which is that the earnings recovery in the region began before the European Central Bank administered quantitative easing.
“Rightly or wrongly, I think the main reason that European growth has picked up is not to do with QE, but has to do with the fact that the oil price fell so sharply and the fact that the euro fell so sharply,” he argued.
“I think those have had a much bigger impact than QE. QE was instrumental in bringing back investor confidence but, to be honest with you, I don’t think it’s had that much of an effect. Remember they haven’t done that much yet.”
“The eurozone doesn’t produce much by way of energy, so the current oil price, all other things being equal, adds about 1 per cent to GDP. When you consider that the eurozone was forecast to grow roughly 1 per cent, we’re talking about a potential doubling of growth.”
What’s more, Conte says that investing in multi-cap European investment vehicles simply dilutes the strong long-term performance of smaller companies in the region.
His JP Morgan European Smaller Companies trust, which he manages alongside Jim Campbell, has a compounded return of 13 per cent per annum over 20 years.
During this time frame, Conte points out that blue chips and the MSCI Europe index has returned 7.2 per cent, which means the £390m trust has almost doubled its return each year.
“When people read newspapers and articles, I genuinely don’t think they realise how much change there has been in the periphery of Europe,” he said.
“Europe is in much better shape. That’s just the big picture but, on a micro level, if you plot European smaller companies against virtually any index in the world, it’s one of the top indices. Whether there’s a reason for that, god only knows, but I suspect it comes from a couple of things.”
“The companies we invest in, for instance, are number one in the world in their respective industries. Why? Because they’re the best. If you go back to 1998, the industrial landscape has changed completely. The companies that have survived and thrived in Europe have done so because they are the best, not because they are the cheapest as they were years ago.”
JP Morgan European Smaller Companies, which has clean ongoing charges figure (OCF) of 1.32 per cent, is the top-performing trust in the IT European Smaller Companies sector over 10 years, delivering a return of 209.63 per cent and outperforming its sector average by 34.76 percentage points.
Performance of fund vs sector over 10yrs
Source: FE Analytics
It is geared at 12 per cent, yields 1.3 per cent and is trading on an 8.8 per cent discount.
Over 20 years, the trust has achieved a total return of 1,259.38 per cent, which 943.74 percentage points more than the MSCI Europe index.
In terms of open-ended investment vehicles, a European smaller companies fund that has outperformed its sector average and benchmark over long-and short-term time frames is Lazard European Smaller Companies, which has been top-decile over one, three and five years.
Despite current manager Edward Rosenfeld having only been at the helm since the start of 2013, the £216m fund has maintained its ability to produce high returns, outperforming its sector average by almost a third over the manager’s tenure.
Performance of fund vs sector and benchmark over management tenure
Source: FE Analytics
Over the same time period, Lazard European Smaller Companies has achieved a top-decile Sharpe ratio, which measures risk-adjusted performance, a top-decile maximum drawdown, which measures peak-to-trough performance, and a top-decile alpha ratio, which measures performance in addition to the benchmark.
Threadneedle European Smaller Companies could also be a good fund to hold over the long term, having achieved a top-decile return of 230.26 per cent over 10 years compared to its sector average of 164.95 per cent.
The £1.2bn fund is headed up by FE Alpha Manager Mark Heslop and is deputy-managed by Philip Dicken, who has also achieved FE Alpha Manager status.
Threadneedle European Smaller Companies has a clean OCF of 0.87 per cent. Lazard European Smaller Companies has a clean OCF of 0.81 per cent.
While there may be plenty of lucrative opportunities in the sector, Informed Choice’s Martin Bamford warns that investors should tread carefully.
“There are plenty of reasons for investors to be running scared of Europe at the moment. This is a relatively small sector, with only around £2.4bn of assets. By way of comparison, that’s only around a tenth of the size of the IA Europe ex-UK sector. Funds in the sector tend to be riskier, with greater volatility and lower risk-adjusted returns than their larger cap alternatives,” he said.
“For investors prepared to take that risk and take a long-term view of investing, there are some interesting funds in the sector to consider. Investors should be prepared to buy when fear is driving markets, as it has been recently in European markets.”
