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Debunking the small-cap risk myth?

23 July 2016

Investors have been flooding into defensive stocks in the wake of the EU referendum, shunning risk and by association small-caps, but FE Trustnet takes a closer look at the perception that junior companies are only for the risk-orientated.

By Jonathan Jones,

Reporter, FE Trustnet

Small-cap funds have been on a dramatic rise over the last three years with many outperforming their larger peers, but what’s more impressive is that they have done so with less volatility.

There remains an opinion among investors that the smaller end of the market is only for people willing to take a bigger risk, such as those with a longer time horizon or those looking to beef up their pension.

However, as large-caps suffer from a plethora of negative factors small-caps have steadily outperformed over the last three years, as shown by the graph below.

Performance of sector vs FTSE 100 over 3yrs

 

Source: FE Analytics

The FTSE 100, which is largely weighted in oil and mining stocks, has been hit particularly hard by the fall in the oil and commodity prices.

Meanwhile, macro issues such as fears of a slowdown in China’s economic growth and political concerns in Europe and the US have also dented large-caps stocks.

But over the last three years, the average small-cap fund (as measured by the IA UK Smaller Companies) has outperformed and done so while being less volatile.

On average, small-cap funds witnessed a slightly lower maximum drawdown – the amount an investor could have lost if buying at the very top and selling at the bottom – than the FTSE 100 over the period, according to data from FE Analytics.

In fact, some 26 IA UK Smaller Companies funds from a possible 44 had a lower maximum drawdown than the large-cap index over the past three years while 15 were less volatile.

 

Source: FE Analytics

Above are the top 10 funds in the sector based on maximum drawdown, with FE Alpha Manager Alex Wright and Jonathan Winton’s Fidelity UK Smaller Companies fund topping the list.

The portfolio also has a FE Risk Score of 64. This measure the volatility of a fund relative to the FTSE 100 which is given a score of 100; funds with a score below this are deemed to have been less risky than the index in recent years.



Despite this, some still view small-cap investing as risky, particularly those who have held poor individual small-cap stocks and are still feeling the effects from their bad investment.

However, holding individual securities is not the same as owning a small-cap fund, says CF Miton UK Smaller Companies fund manager Gervais Williams.

“With individual risk you can see why people have had bad experiences or scar tissue from the past and this has just reinforces the perception that individual stocks can be risky,” he said.

“The area where people then sort of jump to, is they then assume that small company funds in themselves follow the same pattern – in other words large company funds are low risk and small company funds are high risk”.

He’s not alone in this assessment, with Ian Ormiston, manager of the Old Mutual Europe (ex UK) Smaller Companies fund, adding: “I think there’s a perception out there that the whole of small-cap land is full of start-ups full of very high sales growth companies but often with big losses or increasing losses.”

It must be kept in mind that while the last few years have seen relatively smooth returns from small-caps, the asset class has been markedly riskier than large-caps at other times.

The graph below shows the performance of the Numis Smaller Companies Excluding Investment Companies index (which has a high weighting to mid-caps but is a common benchmark in the sector).

Over this time, small-caps were hit by a maximum drawdown than was more than 10 percentage points higher than the FTSE’s and were more volatile.

Performance of sector vs FTSE 100 over 20yrs

 

Source: FE Analytics

As can be seen over the past 20 years, small-caps have had long periods of underperformance, particularly during the 1990s as well as in the aftermath of the financial crisis in 2008.

This can be attributed somewhat to the fact that small-caps have less liquidity and therefore can be more volatile during times of extreme events.

Old Mutual’s Ian Ormiston said: “If you look in ‘99 there was a big relative underperformance because the dot com [bubble] was driven by Telco and big media companies, so small-caps got left behind a bit there”.

Meanwhile, there was a big drop in small-caps during the financial crisis in 2008, when the Numis Smaller Companies index underperformed the FTSE 100 by around 12 percentage points.

But, Ormiston says this is only in the most extreme cases, adding that if the markets are normal then small-caps should outperform. And as the experience of recent years shows, can be less volatile than their larger rivals.

This is shown in the graph, as small-cap funds have performed particularly well against the FTSE 100 since 2012.

Miton’s Gervais Williams says if you look at small-caps over three years or five years they are producing a better return than the main market and this is a pattern he expects to continue.


The reason for this, he says, is that over the last 20 years, investors have enjoyed high global economic growth rates, deregulation of the debt markets - allowing companies to have easier access to capital - and lower interest rates.

Now, however, he said: “World growth is stagnating, institutions are going to find that they need small companies more than they expected the fact they are less correlated to the market is becoming much more interesting for institutions and we’re seeing new capital allocations by institutions into small companies pretty much for the first time in about 20 to 25 years.”

“As it all settles down, then absolutely we would expect small companies to be leading the performance charts. Not just because they’ve had a period of underperformance and will have a bit of a catch up, but because they’re small and they can grow when the world’s not growing.”

One fund investors may wish to take a look at to take advantage of this is the Liontrust UK Smaller Companies fund, according to Skerritts head of investments Andrew Merricks.

Performance versus sector over 3yrs

 

Source: FE Analytics

“It has taken a bit of a dip in the last month or so as have all smaller companies funds, but compare its longer term performance versus its sector and the FTSE and you can see that it is clearly a fund that you can trust so long as you can shut your eyes and ears to some of the short-term noise that accompanies the investment world from time to time,” Merricks said.

Over the last three years, FE Alpha Managers Julian Fosh and Anthony Cross’ £424m fund sits sixth in maximum drawdown and volatility, and is in the top decile for alpha – the risk-adjusted return a fund provides above its benchmark.

It has returned 13.6 per cent in the past three years, ranking it sixth in its sector.

Of course, one significant cloud hanging over the UK small-cap space is the UK’s vote to leave the European Union. With this in mind FE Trustnet will soon look at whether investors should be sticking to home shores for small-cap exposure or whether they should now be looking overseas.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.