The belief that investors sacrifice safety in search of higher returns when investing in small cap strategies has often been borne out by past experience, but research by FE Trustnet has uncovered three funds delivering solid returns with lower volatility. 
Indeed, data from FE Analytics reveals that some funds in the IA UK Smaller Companies sector have provided market-beating returns without the associated risk.
The shift to defensive strategies and quality growth stocks in recent years has placed investors in strategies further up the market cap strategy.
While the Numis Smaller Companies index remain the most common benchmark for small-cap focused funds, comparison with the FTSE All Share provides a different perspective.
The FTSE All Share is 80 per cent weighted to the FTSE 100, home of the most liquid and ‘bond proxy’-like stocks such as big tobacco and utilities companies.
It is therefore a good index for comparison with small cap funds, which for investors seem riskier.
The FTSE All Share has returned 59.57 per cent over the last five years compared with a 104.89 per cent return for the Numis Smaller Companies index. The average IA UK Smaller Companies sector fund rose by 101.66 per cent over the same period.
However, both the Numis Smaller Companies index and average UK smaller companies fund have been more volatile. The index and average fund were 1.5 and 0.29 per cent more volatile respectively than the FTSE All Share (10.13 per cent).
All UK smaller companies funds – with one exception – have outperformed the FTSE All Share over the past five years, but only three have done so with lower volatility.
Risk/return of funds in the IA Smaller Companies sector over 5yrs
Source: FE Analytics
(The SF Webb Capital Smaller Companies Growth has drastically underperformed, losing 51.54 per cent while exhibiting 15.76 per cent volatility.)
Below we look at the three funds in the IA UK Smaller Companies to outperform the FTSE All Share while experiencing lower volatility.
The fund with the lowest volatility in the sector (9.21 per cent) over the past five years is the £376.3m Artemis UK Smaller Companies run by Mark Niznik and William Tamworth.
The three crown-rated fund has a high weighting to consumer services and industrials with little exposure to commodities such as oil and mining companies and holds 2.7 per cent in cash.
Among its top 10 holdings are tech company Computacenter, biotech firm Alliance Pharma and concrete levelling company Somero.
Over the last five years, the fund has returned 105.65 per cent – the lowest of the three funds – but still ahead of the sector and Numis Smaller Companies ex IT benchmark.
Performance of Artemis UK Smaller Companies vs sector, benchmark and index
Source: FE Analytics
The fund is relatively cautious in a high-risk area, focusing on bottom-up stock picking factors such as strong management teams, strong track records and balance sheet stability.
The concentrated portfolio currently holds 79 companies with 56.9 per cent in companies with a market capitalisation of more than £250m and more than a quarter of the fund in companies worth more than £500m.
It has a clean ongoing charges figure of 0.84 per cent and currently yields 1.77 per cent.
MI Downing UK Micro-Cap Growth
The second least volatile fund in the IA UK Smaller Companies sector over a five-year period is the MI Downing UK Micro-Cap Growth fund (9.59 per cent) run by Judith MacKenzie.
The £24.4m fund is the smallest of the three and invests in a highly concentrated portfolio of 29 stocks.
The fund seeks to generate capital growth, whilst retaining a strong focus on capital preservation and generally uses valuation as its jumping off point, focusing on funds that the manager believes are cheap.
It focuses on companies with a market capitalisation of between £20m and £150m and is currently 17.65 per cent weighted to companies worth more than £150m.
The five-crown rated fund has outperformed over the period, returning 142.97 per cent, placing it in the top quartile of funds in the sector.
The largest holdings in the portfolio include Amino Technologies, Pennant International and Redhall Group, with the majority of the fund invested in companies with less than a £50m market capitalisation.
The MI Downing UK Micro-Cap Growth fund has an OCF of 1.4 per cent.
Liontrust UK Smaller Companies
Run by FE Alpha Managers Anthony Cross and Julian Fosh, Victoria Stevens and Matthew Tonge, the Liontrust UK Smaller Companies fund completes the list.
The fund is the fourth least volatile in the IA UK Smaller Companies sector (9.92 per cent) over the past five years.
Managed in accordance with the proprietary Liontrust ‘Economic Advantage’ document, it seeks companies with assets that competitors will struggle to recreate and creating a natural barrier to entry.
The five crown-rated fund focuses on companies with a high degree of intellectual property as well as those which encourage employee equity ownership.
As a result, all smaller companies in the fund must have a minimum 3 per cent directors' equity ownership, which the managers believe motivates key employees, securing a company's competitive edge and leading to better corporate performance.
The £570m fund is predominantly focused on the AIM market, with a 65.9 per cent weighting to the junior market and currently holds 10.8 per cent in cash.
Its biggest overweight is in technology, which accounts for 32.2 per cent of the concentrated 67-stock portfolio and includes the likes of dotDigital and Paypoint among its top 10 holdings.
Performance of Liontrust UK Smaller Companies vs sector and indices
Source: FE Analytics
Over the past five years, the fund has returned 157 per cent (fifth overall in the sector) comfortable beating the sector and indices.
The fund has an OCF of 1.38 per cent and yields 0.26 per cent.