Small caps are generally considered to be riskier than their large cap counterparts and tend to fall harder during market sell-offs, particularly compared with dividend-paying stocks. However, our data shows that the opposite has been true in recent months.
The average fund in IMA UK Smaller Companies has an annualised volatility of 7.57 per cent over the past 12 months, which compares with 8.44 per cent from the average IMA UK Equity Income fund and 9.44 per cent from the average IMA UK All Companies fund.
Tellingly, the least volatile funds in the Equity Income and All Companies sectors have been those with a small to mid cap focus, including John McClure’s Unicorn UK Income portfolio, which has a volatility of just 7.82 per cent over the period.
Volatility, drawdown and downside risk of sectors over 1yr
| Name | 1yr return (%) | 1yr vol (%) | 1yr max draw. (%) | 1yr downside risk (%) |
|---|---|---|---|---|
| IMA UK Smaller Companies | 33.28 | 7.57 | 2.59 | 6.42 |
| IMA UK All Companies | 25.13 | 9.26 | 5.49 | 10.44 |
| IMA UK Equity Income | 23.05 | 8.44 | 5.03 | 8.92 |
Source: FE Analytics
Small cap funds also have a lower max drawdown than their rivals, thanks largely to their effectiveness at protecting against the downside in the market sell-off in May and June of this year.
This is clearly illustrated in the graph below: the average UK Smaller Companies fund lost around 4.5 per cent over the worst of the two-month period, while the average UK growth and UK Equity Income funds lost closer to 9 per cent.
Performance of sectors over 1yr
Source: FE Analytics
UK Equity Income funds remain less volatile than UK small cap funds over three years, but UK All Companies funds have also proved to be more volatile over two and three years.
Of the 300 or so funds in the sector, there are a number with a multi cap focus, but large caps still tend to dominate the top-10 holdings of most portfolios in the sector.
Among the least volatile funds in the IMA UK Smaller Companies sector are those with a micro cap focus, including the likes of Octopus UK Micro Cap Growth and Marlborough Micro Cap Growth, which have a volatility of 4.28 and 6.99 per cent over a one-year period, respectively.
The top-performing funds in the sector over the last 12 months – including Fidelity UK Smaller Companies and Cazenove UK Smaller Companies – have also been significantly less volatile than the average UK Equity Income fund.
Performance of funds and sector over 1yr
Source: FE Analytics
One of the biggest reasons why large caps have been so volatile has been the bumpy ride sustained by miners and other commodity-related industries, which make up a big chunk of the index. The likes of Fresnillo, Aggreko and Tullow Oil have all lost more than 20 per cent in the last 12 months, while Eurasian Natural Resources has lost 44.5 per cent.
Many UK large cap managers who are wary of venturing too far away from their benchmark have no choice but to have some exposure to this area of the market, which has no doubt contributed to the high levels of volatility.
Healthcare also makes up a big chunk of the index and is a major part of many funds in the UK All Companies and UK Equity Income sectors – particularly the latter. Financials also have a significant weighting.
The small cap market is less reliant on any one sector however, meaning funds tend to be less badly hit when a particular area goes out of favour.
Jason Hollands (pictured), managing director of business and communications at Bestinvest, says the assumption that large caps are automatically safer than small caps is a dangerous one to make.
"It’s a trend I’ve noticed recently myself – we use three-year volatility numbers and have noticed some different trends," he said.
"The UK market is now dominated by resources and financials companies. Around 10 companies account for 38 per cent of the whole UK universe, while small caps have just a 3 per cent weighting."
"Looking at broader companies like the FTSE All Share, there is an assumption that there’s more diversification, but that’s just not the case. In the small cap universe there is a lot less stock concentration, and less sector concentration as well."
"When looking at individual shares, there is an argument that they are more risky, particularly those in the early phases of development, which are less liquid. However, when looking at funds it’s a different story because of the concentration risk."
"Small cap funds also have a tighter discipline when it comes to exposure to single companies," Hollands added.
The likes of Marlborough Special Situations, for example, has more than 200 holdings and no single company accounts for more than 2 per cent of overall assets.
By contrast, Neil Woodford’s Invesco Perpetual Income fund has more than 8 per cent in both GlaxoSmithKline and AstraZeneca, and the top-10 holdings account for almost 60 per cent of assets overall.
Interestingly, the FTSE All Share and FTSE 100 in particular have been even more volatile than the average UK Equity Income and UK All Companies funds of late. They have an annualised score of 10.28 and 10.52 per cent respectively over the last year, and lost closer to 12 per cent in the May and June sell-off.
Performance of sectors and indices over 1yr
Source: FE Analytics
The data suggests that UK active funds have been more effective at protecting against the downside than those that simply track the index, as they have been able to avoid problem areas including the miners.
This could be seen as a precursor to a warning recently issued by FE Alpha Manager Toby Ricketts, who said that falling correlations in the market will suit active managers, who will be able to sieve through their chosen index and avoid problem areas – a luxury not available to passive managers.
He points to active managers’ ability to avoid the worst of the 2008 financial crisis as evidence of this.
"What the credit crunch showed us was that banks had led the market and comprised a huge part of the index," he explained.
"However, though a lot of active managers didn’t see this, those who saw the banks were massively overleveraged and avoided them fared much better than those who followed the index."
Hollands agrees: "There’s no doubt that if you’re in an index fund you’re going to be more skewed to certain sectors. If you subscribe to the view that China is going to struggle, this isn’t a good thing, as resources companies are so heavily reliant on demand and make up a big chunk of the [FTSE 100]."
"We’ve gone through a period recently when policy intervention has dictated the direction of markets and everything has largely moved together. If you believe we are entering a period of normalisation, then it should benefit stockpickers," he added.
