Investors who hold overseas smaller companies funds are more than compensated for the extra risk they accept by the high level of return they receive over the long-term, the latest FE Trustnet study shows.

The difference across the world’s developed markets is most notable in Europe. The average European Smaller Companies fund has been a much better investment versus the all-cap Europe ex UK sector on a risk/return basis.

While smaller companies funds have been more volatile than their large cap peers in recent years, the difference is a lot less than most investors realise.

Our data shows that the average European Smaller Companies fund has returned 165.69 per cent over the last decade, with an annualised volatility score of 20.35 per cent, while the average Europe ex UK sector has returned 70.05 per cent over the same period, with a volatility score of 19.75 per cent.

Performance of sectors over 10-yrs



Source: FE Analytics

Aside from the track record, the region looks particularly interesting given the fact that the eurozone crisis has depressed valuations to previously unprecedented levels.

FE Alpha Managers Barry Norris and Alexander Darwall, who specialise in the region, say quality companies that derive the majority of their earnings from overseas can be picked up at bargain prices.

FE data shows that the Sharpe ratio of the average European Smaller Companies fund over the last decade is 0.37 while its all-cap counterpart scored just 0.11.

The ratio measures a fund’s return relative to a notional risk-free investment and the difference in returns is then divided by the fund's volatility. The higher the score, the better the risk-adjusted return.

Returns and volatility of sectors

Name	10-yr returns (%)	Annual volatility (%)
European Smaller Companies	165.69	20.35
Europe ex UK	70.05	19.75
North American Smaller Companies	105.91	18.97
North America	51.36	15.76
Japanese Smaller Companies	27.89	19.92
Japan	13.64	17.08

Source: FE Analytics

By comparison the average North American Smaller Companies fund has a score of 0.21 while IMA North America has a score of 0.05 over 10 years.

The relative outperformance of small cap funds on a risk-adjusted basis is much less pronounced in Japan. The average smaller companies fund has returned 27.89 per cent since July 2002, with an annual volatility of 19.92 per cent, while the average fund in IMA Japan has returned 13.64 per cent with a volatility score of 17.08 per cent.

It is not as easy to draw conclusions when it comes to global and emerging market funds because there are no dedicated sectors and small cap investing in these areas is a relatively new concept.

However, focusing on two comparable funds – Aberdeen Asia Pacific and Aberdeen Asian Smaller Companies, for example – the trend is similar.

The small cap fund has a Sharpe ratio of 0.66 over five years while the Asia Pacific fund has a score of 0.27. Aberdeen Global Asian Smaller Companies is among the best-performing portfolios in the entire unit trust and OEIC universe over this period, with returns of 98.82 per cent, while Aberdeen Asia Pacific has returned 44.85 per cent.

It is a similar story in the Global sectors: McInroy & Wood Smaller Companies, Invesco Perpetual Global Smaller Companies and F&C Global Smaller Companies IT top the charts in the risk/return tables.