Those who are invested in the IA UK Smaller Companies sector could face some “very challenging times ahead”, according to Kepler’s Alex Paget (pictured), who warned the market area is subject to liquidity concerns and drastic changes to portfolio repositioning. 
As such, he said the investment trust structure is far better-suited to gaining exposure to the sector; while closed-ended smaller companies trusts have been more volatile in the past, they have tended to outperform their open-ended counterparts over the medium and long term.
The research analyst explained that this outperformance is largely the result of trust managers running a fixed pool of capital and being able to gear to enhance returns. As such, he said the managers don’t have to worry about inflows and outflows both in terms of returns and liquidity risk.
“It is important to note that while we predominantly cover investment trusts, we don’t aim to bad mouth their sexier, more popular and (largely) easier to understand open-ended rivals,” Paget said.
“Just like in the closed-ended space, we believe many open-ended funds are run by high-quality managers who have delivered significant outperformance to boot.
“However, one of our core beliefs is that the closed-ended structure is far better suited to certain areas of the market and in particular UK small-caps where, in our view, it helps investors mitigate unforeseeable (but usually liquidity-related) risks.”
Kepler’s research shows the average number of individual holdings across IT UK Smaller Companies trusts has been consistently lower than open-ended funds in the market area, as the closed pool of capital allows managers to adopt longer-term time horizons and run more concentrated portfolios.
That said, Paget pointed out this hasn’t been the reason trusts in the sector have outperformed open-ended funds.
In fact, the research found that open-ended funds within the IA UK Smaller Companies sector have had a comparatively higher weighting to micro-caps than their closed-ended counterparts over five years, and continue to do so.
Source: Kepler Trust Intelligence
“There are various reasons why this could be the case of course, one of which could be that trust managers simply haven’t seen value among the smallest members of the index,” the research analyst reasoned.
“However, given they are running a closed pool of capital, if they did decide that micro-caps were the place to be, they would be able to allocate to them without taking undue liquidity risk.
“We would argue, however, that it isn’t a luxury available to the largest and most popular open-ended UK small-cap funds.”
Paget said open-ended funds tend to attract greater inflows as they outperform, which means their portfolios can start to change. For instance, they may invest in companies further up the cap spectrum to minimise liquidity risk.
Kepler’s report shows that funds such as Marlborough Special Situations, Old Mutual UK Smaller Companies and Liontrust UK Smaller Companies have all reduced their micro-cap exposure over the past five years while the size of their fund has simultaneously increased.
Performance of funds vs sector over 5yrs
Source: FE Analytics
“Of course, these managers could have simply run their winners and watched their successful micro-cap calls become significantly larger companies or they could genuinely have seen better value further up the market-cap spectrum over the past five years,” Paget pointed out.
“Both arguments are valid, however, do they have the underlying liquidity to buy micro-caps now like they did before?
“If not, are these funds really the same beasts they once were, and could a potential investor really expect them to generate the same level of outperformance now they are more constrained by size?”
He argued that the combination of the open-ended fund’s AUMs increasing, combined with the fact they own more micro-caps than their closed-ended peers (despite their weightings falling) means they could end up taking increasingly larger stakes in the companies they hold in their portfolios.
Kepler’s research estimates that the eight largest members of the IA UK Smaller Companies sector own an average of 3.06 per cent of the total shares of their top 10 stocks.
“This isn’t an issue in itself, of course,” Paget continued. “However, the years since the global financial crisis (a period when these funds have become ever larger) have been highly supportive for UK small-caps and such long time frames of high returns can breed complacency.
“Plus, funds in the IA UK Smaller Companies sector have never been as big as they are today as consolidation in the industry has left just a select number of funds on dominant gatekeeper’s buy lists.
“The question is, therefore, if conditions change, smaller companies fall massively out of favour and investors start heading for the exit door en masse, would these large open-ended UK small-cap funds be able to sell these large positions in less-liquid stocks without incurring hefty losses?”
The research analyst said that, not only will the portfolios of the best-performing funds change over time as a result of inflows piquing investor interest, the underlying portfolio can be affected by other unit holders in the fund.
Therefore, if other investors in the fund sell out at once the manager can become stuck and, in most cases, will sell whatever they can.
“Plus, while there have undoubtedly been some top-performing open-ended funds run by top-quality managers, many of those funds aren’t the same offerings that outperformed in the first place and will struggle to replicate their past outperformance from here due to liquidity constraints,” Paget continued.
“Of course, by going down the closed-ended route, investors take other risks – most of them relating to discount volatility. However at this point in time, thanks to Brexit-related uncertainty, the average trust in the AIC UK Smaller Companies sector is trading on a wider discount than the five-year average.
“As such, from here, we believe that going with trusts is the best way to allocate to UK smaller companies over the long-term as they are offer relatively attractive discounts and managers can afford to be genuinely long-term in their approach.”
However, managing director of Tilney Group Jason Hollands argued that some findings from the report are outcomes of there being a fairly limited number of smaller company investments trusts relative to the number of open-ended funds operating in the space.
“At the end of the day, the principle of caveat emptor needs to apply,” he said. “Investors do need to be aware of potential liquidity constraints when investing in open-ended funds with significant exposure to micro-caps as this could prove problematic in extreme market conditions.
“Closed-ended structures are inherently more suited to holding illiquid asset classes. However, it is worth pointing out that as far as I can recall even during the darkest days of the 2008 global financial crisis when certain property funds and enhanced cash funds froze redemptions, there was no widespread pattern of UK small-cap funds suspending dealing.”
That said, he is very mindful of liquidity and capacity constraints when it comes to the UK smaller companies space; the team at Tilney Group has previously removed funds from their buy-list when they have become too large despite holding the managers in high regard. He is also generally supportive of decisions by managers to soft-close funds when they feel capacity is being reached.
“Investments we currently like include Neil Hermon’s £549m Henderson Smaller Companies Investment Trust in the closed-end space – trading at a 12.7 per cent discount to NAV - and the £271m Franklin UK Smaller Companies fund which is run by Paul Spencer,” Hollands added.
In an article tomorrow, we look at five UK smaller companies investment trusts that Kepler believes are attractive options for investors.