Some 70 per cent of investors no longer believe that large-caps are the ‘safest’ area of the UK equity market, according to a recent FE Trustnet, a result which is certainly at odds with longer term consensual views. 
The poll, in which more than 1,200 readers voted, showed that 50 per cent believe FTSE 250 stocks offer the safest exposure to UK equities and 20 per cent think small-caps are the safest stocks, meaning just 30 per cent thought large-caps are the most durable to shocks in the current environment.
These results go against the consensual and traditional views of equity market risk, as most have tended to believe that while smaller companies offer the chances of greater returns than large-caps, they also offer a bumpier and more volatile ride.
However, over recent years, that argument has been turned on its head.
Thanks to macroeconomic headwinds such as China’s growth slowdown, falling commodity prices, uncertainty over US interest rates and geo-political risks, the international-facing FTSE 100 index lost 1.32 per cent and delivered a maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – of 13 per cent in 2015.
On the other hand, the FTSE 250 and FTSE Small Cap indices have delivered returns of 10 per cent with half the maximum drawdown as investors favoured more domestically-orientated stocks that were benefitting from an improving UK economy and business friendly government.
Performance of indices in 2015
Source: FE Analytics
These trends have affected more than just total returns, though, as a recent article showed that the UK equity funds with the lowest FE Risk Scores – which measure the volatility of a fund relative to the FTSE 100 – are now those with a clear mid and small-cap bias.
Over the past two years, for example, seven of the top 10 funds for risk-adjusted returns (as measured by their Sharpe ratio) in the three main IA UK equity peer groups – IA UK All Companies, IA UK Equity Income and IA UK Smaller Companies – invest either predominantly or solely outside of the FTSE 100 index.
The top 10 UK funds for risk-adjusted returns over 2yrs
Source: FE Analytics
These include the likes of CF Miton UK Value Opportunities, PFS Downing UK Micro Cap and MFM Techinvest Special Situations.
While not necessarily the best metric for gauging risk, it is a similar story when you look at the UK funds with the lowest annualised volatility over the past two years.
The UK funds with the lowest annualised volatility over 2yrs
Source: FE Analytics
Unfortunately, as with any quant-based metric, these are backward looking so are investors right to deem smaller companies to be safer than large-caps in the current environment?
Certainly, thanks to the poor performance of some of the FTSE 100’s largest names, FTSE 250 stocks on average are more expensive at the moment and certain UK managers have rotated their portfolios away from mid-caps as a result.
Bloomberg data shows, for example, that the FTSE 100’s P/E ratio is 16.1x compared to the FTSE 250’s P/E of 16.7x.
There is also huge uncertainty surrounding a potential ‘Brexit’ from the EU later on this year, which – if it happens – could well hinder UK focused companies while, thanks to likely sterling weakness, international facing large-caps mat well receive a boost.
However, FE Alpha Manager Harry Nimmo, who runs the Standard Life Investments UK Smaller Companies fund, says that he has a “lot of sympathy” with the view that smaller companies are now safer than large-caps given the make-up of the FTSE 100 index.
“One can always draw up examples of mega-caps over the past 15 years that have cost investors almost everything. I would accept, though, that smaller companies as a group are more risky than your average large-cap. I think that is still the case,” Nimmo said.
“However, I think the gap in risk levels is definitely narrower than it was 10 or 20 years ago.”
As Nimmo points out, larger companies have historically tended to be safer than mid and small-caps.
According to FE Analytics, while the two smaller companies indices have comfortably outperformed the FTSE 100 over the past 20 years, they have also delivered considerably higher maximum drawdowns at the same time.
Performance of indices over 20yrs
Source: FE Analytics
Ben Willis, head of research at Whitechurch, points out that while large-caps (which tend to generate much more of their earnings from overseas) are likely to benefit from Brexit-induced sterling weakness, at the same time, the FTSE 100 index is littered with companies that have very challenged dividends.
He says, however, that investors shouldn’t make long-term investment decisions based on the recent past.
“Many investors will look at how well certain areas of the market have performed, particularly during periods of global market weakness and wholesale risk aversion,” he said.
“Again this can be skewed as market sell-offs can be driven by liquidity, with the most liquid asset being sold off first – i.e. large caps. This was definitely the case last August. Due to their relative illiquidity, UK small and mid-caps did not suffer the same correction in price as large caps.”
He added: “One thing that the poll maybe highlights is that more investors will be favouring an active stockpicking approach rather than an index tracker.”
Charles Stanley Direct’s Rob Morgan (pictured) understands why so many don’t believe large-caps to be safe anymore, but says investors need to remember why they are ‘large’ in the first place. 
“I still think large caps do represent the safest taken in aggregate, but really it’s more a question of the type of business, the sector its in and the state of its balance sheet than size,” Morgan said.
“Big businesses tend to be more mature, diversified and able to withstand difficult times, but there are small businesses with these traits too - and larger ones that sail close to the wind.”
Of course, while there is also a certain level of safety in large companies over less mature businesses, one of the biggest risk facing investors is the price they pay for a security and Hawksmoor’s Ben Conway says investors should bear that in mind.
“For us, risk is best indicated by the valuation of an asset. The cheaper the asset, the greater the margin of safety and the smaller the probability that an investor will permanently destroy his or her capital. Risk is decidedly not historic volatility,” Conway said.
“From today as a starting point, the recent weakness of sterling will no doubt prove to be a boon to those companies earning a lot overseas – large companies clearly fall into this category. But more generally, we believe that very small company shares still offer the best relative value.”
“They may be far less liquid than larger companies, but you can mitigate against this by investing in an investment trust or a small open-ended fund that promises to limit fund size.”
Finally, Simon Evan-Cook – senior investment manager at Premier – believes taken as a whole, large-caps are no longer the safest area of the UK market.
He points out that a talented smaller companies manager has the ability to build a “super-conglomerate” portfolio of the best and most attractively valued smaller businesses to create a diversified offering.
He added: “In contrast, when buying a large cap, there may be one part of the business that’s great, but you have to buy all the other parts to go with it.
“If you consider true “risk” to be permanent loss of capital, as we do, then I believe there is just as much chance of that happening in a large cap portfolio as there is in a small-cap equivalent. It’s just that in a large-cap portfolio, parts of the portfolio can effectively go bust, but are hidden within the conglomerate, which lives on, albeit with a permanently lower share price”.
Performance of indices over 15yrs
Source: FE Analytics
“But forget the highfalutin arguments, a quick look at the FTSE 100’s performance versus the Numis Smaller Companies Index over the past 15 years tells you everything you need to know. Large caps have been consistently damaged by corporate disasters (banks, mining companies, oil companies and supermarkets etc.) while their smaller peers have sailed on.”
Of course, investors don’t have to make the decision of whether to invest in larger or smaller companies in their portfolio so FE Trustnet will take a look at the multi-cap funds the experts expect to flourish in this choppy market later today.
