Small and mid-cap funds have dominated UK markets this year, following the internationally-facing FTSE 100 index being hit by a number of global headwinds including the China growth slowdown, plummeting commodity prices and impending rate rises from the Federal Reserve.
The improving UK economy has also helped smaller companies due to their domestic focus, and this year’s general election results provided a further sentiment boost towards home markets.
Performance of indices in 2015
Source: FE Analytics
When taking a look at the IA UK Equity Income sector, for instance, the top quartile is littered with small and mid-cap orientated companies in 2015, with the likes of CF Miton UK Multi Cap Income, Montanaro UK Income, Marlborough Multi Cap Income and Unicorn UK Income taking some of the top spots in terms of performance year-to-date. 
Simon Moon and Fraser Mackersie (pictured), co-managers of the five crown-rated Unicorn UK Income fund, say that investors seeking UK exposure will continue to do well by investing in the small and mid-cap space, and that the run of positive performance seen in smaller stocks isn’t set to taper out any time soon.
“This is not just a Unicorn ‘house view’ – it remains steadfastly at the core of what we do. As dividends from the traditional UK large-cap stocks come under increasing pressure and concentration risk becomes an issue, there are some excellent businesses further down the market capitalisation scale that we feel can both grow earnings and deliver attractive levels of income,” they said.
However, not all managers agree with this sentiment, as many believe that give smaller companies have performed so strongly and large-caps have struggled, the valuation dispersion between the two ends of the spectrum will start to change.
IBOSS’ investment director Chris Metcalfe told FE Trustnet last week that he is considering buying into large-cap value funds to diversify his exposure to smaller companies, especially seeing as many UK multi-cap managers are underweight FTSE 100 stocks.
“Our UK portion of the portfolios has been one of our best performing sectors, but the best period we have had has been the past six months or so. Now, if you can find a set of market conditions that are fantastic for [a small and mid-cap bias] there will be another set of circumstances that will provide the opposite for us.”
FE Alpha Manager Alex Savvides, who runs the five FE Crown-rated JOHCM UK Dynamic multi-cap fund, agrees that there are increasingly good opportunities at the larger end of the size spectrum, and he expects this trend to continue in the near future.
Like Metcalfe, he believes that now is the optimal time to buy into blue-chips while valuations are cheap and sentiment towards them is low.
“It just so happens some of my most interesting ideas at the moment are in the FTSE 100 and they are right at the top end. You will get small-cap returns from mega-cap stocks over the next three years and if you are not in them, you will miss out.”
In fact, over the last six months, the performance gap between the FTSE 100 and the FTSE 250 and FTSE Small Cap indices has begun to narrow.
Over one year, the FTSE 100 lost 2.53 per cent compared to the FTSE Small Cap which returned 8.32 per cent and the FTSE 250 which returned 12.05 percent.
Over the last month though, there is only a 24 basis point difference between the blue chip index and the small-cap index and a 256 basis point difference between the FTSE 100 and the FTSE 250. This is largely because bombed out mega-caps, such as the oil majors and mining stocks, have led the rally since the August sell-off.
Performance of indices over 1month
Source: FE Analytics
Mackersie and Moon, however, believe that there are numerous tailwinds on the horizon for UK markets, which will only be truly utilised if investors are focusing on domestically-facing stocks.
“We are starting to see a first meaningful increase in real wages with the consumer benefiting from both greater spending power and growing confidence,” they said.
“The combination of interest rates which look set to remain lower for longer and the effect of ‘imported deflation’ – from the falling oil price and cheaper imported goods leading to reduced costs – suggests that the consumer story is on course to remain strong.”
A majority of the duo’s activity over the last few months has been within the IPO and secondary fundraise markets.
One new addition to the £629m fund is Hostelworld, which commenced its first day of trading on 28 October.
It is the world’s leading online hostel booking platform, and was launched by hostel owner Tom Kennedy and entrepreneur Ray Nolan more than 15 years ago.
“With good long term growth prospects, international exposure, a high yield and low PE, we bought the stock for each of the Unicorn UK Income, UK Growth, UK Smaller Companies and Acorn Income Funds when it floated on the main market,” Moon and Mackersie said.
“We have now assumed an overall position of more than 5 per cent of the company. Pleasingly the shares have already increased in value since IPO.”
Performance of stock since IPO
Source: FE Analytics
Another example of a UK small-cap the managers are particularly excited about is Conviviality Retail, which owns a number of off-license chains including Bargain Booze, Bargain Booze Select Convenience and Thorougoods.
Unicorn’s holding in the stock has doubled cumulatively within the UK Income fund, and has recently been introduced to the UK Growth and UK Smaller Companies funds.
Since it floated on the AIM market in July 2013, the stock has returned 68.82 per cent, compared to its index’s return of 4.21 per cent.
Mackersie and Moon have been at the helm of Unicorn UK Income since January last year and took on sole responsibility of the fund in June 2014 following the death of John McClure.
Over this time, it has returned 7.69 per cent compared to its peer average’s return of 8.08 per cent and its benchmark’s return of 1.86 per cent.
The fund has a clean ongoing charges figure of 0.81 per cent and yields 3.51 per cent.
