Japan and the UK have been the two best markets for investing in smaller companies over the past five years on a range of performance metrics, data from FE Trustnet has revealed.
Over the long-term, many investors claim that while investment lower down the market cap spectrum can be riskier, the potential returns on offer can be greater than those on offer in the large-cap space where growth is harder to come by.
Yet, investors are unlikely to take smaller company exposure across different geographies, making it important to consider which markets to take the additional risk and where to gain exposure via larger company-focused funds.
Ryan Hughes, head of fund selection at AJ Bell, said: “Traditionally you would think regionally: so what’s the best way to invest if you like Europe, for example?”
Source: FE Analytics
Comparing smaller companies to their large cap peers, Japan leads the way with the IA Japanese Smaller Companies outperforming the IA Japan sector by 40.79 percentage points over five years.
Hughes said: “Three years ago I had this exact conversation and went through exactly this thought process because we looked at the world and said we really liked Japan so what’s the highest beta way of playing this – which was through small-cap.
“I think that would be true across any sector any sector really – if we like a region we think about how we invest or exploit it.”
Premier Asset Management fund manager Simon Evan-Cook, says that the outperformance however could be due to the fact that the Japanese small-cap sector only contains six funds.
“This means that it’s more susceptible to statistical quirks, given the small sample size. It’s also that sparse because a few funds have been shut down in recent years,” he said.
“This will have been Darwinian in its nature, so not only are you not including the impact of the ‘dead’ funds – which were almost certainly weaker – but you’re also left with a selection of very good, highly active managers.
“I’d additionally suggest most of those funds have a growth bias, and small-cap growth stocks have been flying in Japan for several years now, so that bias will also help to explain the big gap.”
The next highest returning sector is the IA UK Smaller Companies sector, which has outperformed the average IA UK All Companies fund by 36.64 percentage points.
Evan-Cook said: “In respect of the UK small-cap sector outperforming the IA All Companies sector, this doesn’t surprise me at all.
“For one thing, the All Companies sector contains a lot of sludge, which is to say ‘closet trackers’. These drag down the performance of that particular sector, while there are also a fair few trackers which are naturally going to underperform their market too.”
“The IA UK Smaller Companies Sector doesn’t contain any trackers, because there aren’t any. It also doesn’t contain much in the way of closet trackers either.
“Even just the absence of those closet trackers may be enough to give them an advantage over their multi-cap peers.”
However, he says that closet trackers are unique to the UK sector, so it doesn’t explain any other regional differences.
One thing that might is the fact that the further you get away from the UK, the fewer small-cap funds there are – such as with Japan.
“I guess that’s because UK investors feel they’re taking enough risk just investing away from the Motherland, without compounding that by doing it through smaller companies,” Evan-Cook said.
Looking at small caps from an active perspective, small-caps in Japan again come out on top versus the MSCI Japan Small Cap, beating the index by 19.08 percentage points over five years.
Source: FE Analytics
A bespoke emerging markets smaller companies sector constructed by FE Trustnet has returned just 60.32 per cent compared with triple-digit returns from other smaller companies sectors.
However, that performance is enough to make it one of the best performers against a comparable benchmark, outperforming the MSCI Emerging Markets index by 12.72 percentage points.
Hughes says the emerging market smaller companies funds are a classic example of thinking about time horizons, which he says are key for investing in smaller companies.
“With small-cap you’re taking in the liquidity premium and you need to hold it for a longer term so if I want a short-term beta that pushes me towards large-caps because it’s more liquid and it’s easier,” he said.
“If I am thinking about a much longer term tactical positioning then I think that plays to small-cap strength.
Hughes (pictured) added: “If I want emerging market exposure and I have the ability to take a five-year view then if I buy large-cap generic global emerging market [fund], I am getting Chinese state-owned enterprises, I am getting large incumbent. 
“Am I getting tomorrow’s winners or am I getting yesterday’s winners? And in a market like global emerging markets which is far more dynamic and is evolving quickly you need to find tomorrow’s winners and I think that absolutely points you to small cap investing.”
The worst in comparison to a comparable benchmark index is the IA European Smaller Companies sector, which despite beating its large cap peers by 17.83 percentage points, has trailed the MSCI Europe ex UK Small Cap by 25.68 percentage points.
This is followed by the IA North American Smaller Companies index, which has lagged the small-cap focused Russell 2000 by 8.7 percentage points.
Hughes says these areas have struggled as quantitative easing has benefited larger companies and hindered the growth of some smaller companies.
“I guess the premise is that with quantitative easing (QE) it has fuelled all-cap investing but large-caps have been the beneficiaries of that and I guess that hasn’t been the case everywhere,” he explained.
Indeed, a passive vehicle would also be weighted higher to the largest companies in the sector – which are likely to benefit from trackers – while active managers have been looking further down the market for outperformance.
However, this is the second-best performer when compared to the other smaller companies sectors, having returned 117.73 per cent over five years.
“The interesting factor with the US and Europe is QE – Japan is a bit of an outlier there as that’s been currency led – but QE is the factor there.”
However, for those investors looking for the best area on an absolute basis, Japan again comes out on top, followed by the US.
But Premier’s Evan-Cook says whether you compare smaller companies sectors to each other, their index or their large cap peers is irrelevant.
He said: “I’d say it’s interesting to understand the reasons for both sets of discrepancies but it’s difficult to say one is more important than the other.
“Ultimately the most important thing is to be able to find a great small-cap fund that adds value over its own index, as well as its larger-cap equivalent. If understanding the sector’s nuances helps you to do that, then so much the better.”
As such, in an upcoming series, FE Trustnet will look under the bonnet of each smaller companies sector and look at some of the top performing funds within them.