Over the long term, small cap stocks have outperformed their larger rivals, with varying degrees of success depending on the region they are listed in, but investing in smaller companies can be more volatile. 
In a study conducted by FE Trustnet, we showed that the UK, Europe and the emerging markets were the areas that small caps had outperformed the most relative to the same region’s large caps.
Parmenion investment manager Stephen Lennon said: “For investors that can tolerate the volatility of small caps, and for investors that are going to be holding their money for quite a long time, the data clearly shows there is an additional risk premium that can be captured.”
Performance of small cap and large cap indices over 3, 5 and 10yrs
Source: FE Analytics *Small-cap outperformance measured in percentage points
With this in mind, below are three portfolios recommend by fund pickers from each of the regions where small caps have significantly outperformed their larger peers.
Liontrust UK Smaller Companies
Parmenion’s Lennon choice for UK exposure to small caps is the five crown-rated Liontrust UK Smaller Companies fund, run by FE Alpha Managers Anthony Cross and Julian Fosh, who use the firm’s ‘economic advantage’ model whereby they focus on companies with durable characteristics such as ownership of intellectual property, recurring revenue streams and strong distribution channels.
Also co-managed by Victoria Stevens and Matthew Tonge, Lennon says that “within our one model where we explicitly allocate to small cap we use Liontrust”.
UK small caps had the largest relative outperformance by any of the regions studied (15.24 percentage points), and were 29.55 percentage points ahead of the average of the four other regions.
Lennon says the fund has “demonstrated really excellent long-term risk-adjusted returns” and has been able to stick to, and focus on, companies with sustainable business models.
Performance vs sector and benchmark over 5yrs
Source: FE Analytics
Indeed, as the above graph shows, the fund has outperformed its benchmark and sector over five years, with returns of 148 per cent.
Over the period, the £468m fund is also in the top quartile for volatility, with just 10.44 per cent, while its Sharpe ratio, which measure risk-adjusted returns, is top among its sector peers.
The fund is also top for maximum drawdown – the most an investor could have lost if buying and selling at the worst possible times – and has the highest alpha generation relative its benchmark of any of its peers.
“They’ve absolutely churned out really attractive risk-adjusted returns which is exactly what we look for when we’re selecting funds,” Lennon said.
Liontrust UK Smaller Companies has a clean ongoing charges figure (OCF) of 1.38 per cent.
While the UK small caps have outperformed the most over a five year period, over ten years the mantle is passed to emerging market smaller companies.
Over a 10 year period, emerging market small caps outperformed their large cap rivals by 52.63 percentage points, due somewhat to the bull run in the early 2000’s.
With the sector receiving some love in recent weeks, Simon Evan-Cook, senior investment manager at Premier Asset Management, suggests the Schroder Small Cap Discovery fund as his choice for smaller company exposure in the region.
“In the emerging markets we have the Schroder Small Cap Discovery fund which has a very heavy Asian bias but does cover all of the emerging markets.”
Performance vs MSCI Emerging Markets Small Cap since launch
Source: FE Analytics
Since its launch four years ago, the fund, run by Matthew Dobbs and Richard Sennitt has outperformed the MSCI Emerging Markets Small Cap benchmark by more than double, returning 59 per cent to investors.
“It has a fund manager who’s fairly pragmatic so he’s either looking for cheap companies or companies with a growing but not overpaying for it. He’s another one with a good track record,” Evan-Cook said.
Schroder Small Cap Discovery has a clean OCF of 1.01 per cent.
“In Europe we have F&C European Small Cap ex UK run by Sam Cosh. He’s a man who looks for high quality European companies that will grow steadily over time,” Premier Asset Management’s Evan-Cook said.
European small caps have consistently outperformed their relative large caps over three, five and 10 year periods.
However, the fund, run by FE Alpha Manager Cosh and Lucy Morris, was only launched last year, and has had a tough start when compared to its sector and benchmark.
Performance vs sector and benchmark since launch
Source: FE Analytics
The £81m fund has also been one of the most volatile among its peers, and is also in the bottom quartile for its risk-adjusted returns (as measured by its Sharpe ratio) over that time.
However, its managers have a goof long-term track record of investing in European small-caps and Evan-Cook says the fund “doesn’t care about any benchmark – it’s just concerned about making a decent return for investors”.
Square Mile Research adds: “Whilst in the long run we believe this outcome is achievable, over shorter time periods, the fund is exposed to the movements in European stock markets and can experience sharp fluctuations in performance.”
“Investing in good businesses that can generate high and sustainable returns on capital and that operate with a distinct competitive edge over rivals, must seem to any investor, an attractive proposition.”
F&C European Small Cap ex UK has a clean OCF of 0.84 per cent.
