Small-cap equities have a “durable attractiveness”, according to David Walton, manager of the Marlborough European Multi-Cap fund, who says investors should look to add to their exposure to funds in this area. 
The lower end of the market is often perceived as riskier, with many noting the chances of a company going bust more likely than it becoming the next Google. Throw in poorer liquidity further down the market spectrum and it’s easy to see why most view large-caps as the ‘safest’ way to play the equity market.
There are economic cycles and at times small-cap indices perform badly compared to the wider market, Walton (pictured) concedes, but the potential rewards, coupled with prudent strategies to protect from too much downside risk, should be enough for investors.
He said: “If you get it right you benefit from a smaller company becoming larger, and if that happens then the returns can be very large. So that’s, if you like, the durable attraction to small company investing.”
So for those wanting exposure to smaller companies, but hoping to minimise the downside risk, FE Trustnet asks managers of small-cap funds how they are reducing volatility while making positive returns for investors.
Marlborough European Multi-Cap
Walton’s five crown-rated fund has more than a quarter (25.4 per cent) of its portfolio in small-caps, which it defines as companies with a market capitalisation of between €250m and €1bn, with 47 per cent of its exposure in the micro-cap space (companies worth up to €250m).
“We have some quantative risk controls but the most important one is to get as many of the stock calls right as possible,” Walton said.
But he says the first risk mitigation tool he uses is his process in picking stocks – scrutiny of the management company.
“The single most important factor for us investing is the company management. We have to make as thorough an assessment as possible of the company’s management and whether they are good and trustworthy.”
He pays particular attention to the longevity of the management team and holds stocks with a chief executive who has been in the role for, on average, 11 years.
“You’re making an assessment of the people that you meet at the company so it’s not a precise job, but it’s about looking at their previous experience, how long they’ve been in this role and how realistic their view of the company really is”.
The other, more quantative, option he employs is diversification, with his £33m fund holding a maximum of around 2 per cent in a stock.
The fund holds 89 stocks at the time of writing, but its highest weighting is just 2.2 per cent, and Walton says “you never know the full situation at any company”.
Albeit short, his track record speaks for itself. Since taking over the reins near the end of 2013, the fund has outperformed the MCSI Europe ex UK and its sector (the IA Europe ex UK) by more than double.
Performance vs sector and MSCI Europe ex UK since manager start date
Source: FE Analytics
Not only this, but the fund ranks in the top quartile among its peers for volatility (10 per cent) which is also lower than the MSCI Europe ex UK.
Meanwhile, the fund’s Sharpe ratio, which measures risk-adjusted returns, is second among its peers since Walton took charge.
Another who believes that diversification is a good way for managers to reduce the risk in the small-cap space for investors is Gervais Williams, who runs the CF Miton UK Smaller Companies with FE Alpha manager Martin Turner.
He says, “While in large-cap portfolios you can get holdings of 5 to 10 per cent in individual stocks, in an aggregate small company fund you normally get around 2 or 3 per cent.”
While some funds, including his own CF Miton UK Small Companies fund, can have slightly bigger holdings (his biggest weighting is in Fulcrum Utility Services at 4.23 per cent), this is still lower than a many large-cap portfolios.
“Generally small company funds are much more diversified, they tend to have much less specific risk and on the most part they tend to have a much wider range of sectors,” Williams said.
“Portfolios are less volatile in aggregate terms, they’ve got more potential to grow and to buck economic trends, and most importantly they are less correlated to the market.”
Performance vs sector and FTSE All Share since launch
Source: FE Analytics
Since launch in 2012, the £143m fund has provided a 77 per cent return to investors, more than its sector and the FTSE All Share.
However, it has been more volatile over the period, ranking in the bottom decile, over a three-year period, largely due to the mass sell-off and sector-wide volatility experienced during 2012.
Indeed, when looking over a two-year period, the fund ranks in the top decile for volatility among its peers, and only slightly below the FTSE All Share.
Old Mutual Europe (Ex UK) Smaller Companies
Ian Ormiston, manager of the €210m Old Mutual Europe (Ex UK) Smaller Companies fund, uses a different approach to the others by focusing on ‘boring’ companies within the sector to alleviate some of his risk.
“I think a lot of people focus a lot on these lottery ticket type investments and perhaps perceive that’s the majority of the sector and there are certainly loads of those type of companies out there, but most of the funds I would say invest in slightly more mature profitable earnings growth as well as sales growth type companies, and that should reduce the volatility.”
“For us we take it a step further and in terms of sectors - it’s a case of finding boring simple businesses.”
To do this, he looks at businesses that do not attract a lot of competition that are in relatively predictable sectors, such as consumer and industrial companies.
“Those are types of areas where you can find that well run, tedious, high return type business,” he said.
Since launch, the fund has returned more than its sector and the MSCI Europe ex UK index, while remaining almost one percentage point less volatile than the wider market.
Performance vs sector and MSCI Europe ex UK since launch
Source: FE Analytics
Over that timeframe, it has had the fewest negative monthly periods, while it is in the top third of its peers for Sharpe ratio and in the top half for annualised volatility.
