One of the major risks with investing in smaller companies, apart from the chance of permanent loss of capital, is that there are much lower levels of liquidity in that part of the equity market compared to large-caps.
This issue of liquidity has become very apparent over recent years as top-performing funds in the IA UK Smaller Companies sector such as Fidelity UK Smaller Companies, Schroder UK Dynamic Smaller Companies and, more recently, R&M UK Equity Smaller Companies have all had to close their doors to new investors as a result of strong inflows.
The reason why so many smaller companies-orientated funds have had to ‘soft-close’ is because size is massively important when you are plunging the depths of the FTSE All Share.
For example, say a manager of a £400m fund wanted to take a relatively but not overly high conviction position by allocating 3 per cent of their assets in a £50m market-cap company, they would have to own 24 per cent of the business.
Of course, the manager may wish to make that decision but it puts his or her investors at real risk because if they were to see sharp outflows it would be very difficult and costly to try and offload that amount of a small-cap’s shares quickly.
Managers can try and mitigate that risk or counteract a growing AUM by either increasing the number of holdings within their fund or simply start investing in larger companies. While both those options increase liquidity, they can also hurt relative performance as they are no longer the high-growth fund that led them to outperform in the first place.
Problems surrounding liquidity and small-cap funds have always persisted, but due to the changing nature of the industry, funds’ shelf-lives are becoming shorter and shorter as investors flood towards top-performing and highly-rated managers.
This is especially the case in small-cap land, as it doesn’t take long for a popular fund to more than double in size.
The R&M fund, which soft-closed recently, is a good example of this. FE data shows the fund has topped the sector and has massively outperformed its benchmark over the last three years with returns of 136 per cent and over that time its size has increased from £27m to £550m.
R&M UK Equity Smaller Companies’ AUM over 3yrs
Source: FE Analytics
To be fair to R&M, though, they wrote to investors last year alerting that they would look to soft-close if the AUM was to surpass £550m. Interestingly, there are three funds in the sector which are still open and have AUMs of more than £800m.
That’s an aside, of course, but given the disadvantages associated with open-ended funds, aren’t investment trusts a far better way for investors to gain access to such an illiquid area of the market?
After all, as a result of their closed-ended structure investment trust managers don’t have to worry about inflows and outflows and can therefore focus on long-term investment ideas without fear of redemptions.
On top of that, as various FE Trustnet studies have highlighted, investors would have been far wealthier if they had stuck with trusts rather than funds over the longer term.
Of course the past is no guide to the future, but the average trust in the IT UK Smaller Companies sector has beaten its average rival in the IA UK Smaller Companies sector over one, three, five, 10, 15 and 20 years.
Source: FE Analytics
This is also shown when you compare the performance of trusts and funds run by the same manager.
A great example is with FE Alpha Manager ‘hall of famer’ Harry Nimmo, as his Standard Life UK Smaller Companies Trust has outperformed his Standard Life Investments UK Smaller Companies fund by more than 150 percentage points over the past decade.
Performance of trust and fund versus index over 10yrs
Source: FE Analytics
That’s not to say trusts don’t come with their own risks, though.
Features such as gearing and discount volatility are among the main drivers of trusts’ returns, but they both mean they can underperform in falling markets.
FE data also backs up this point, as the average trust in the IT UK Smaller Companies sector has had a larger maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – and higher annualised volatility than their open-ended peers over 10 and 15 years.
However, the point about investing in small-cap portfolio is that investors should be focusing on long-term gains, so shouldn’t investors in in smaller companies be able to stomach a high level of short-term volatility anyway?
Also, while shareholders can get hit by the ‘double whammy’ effect of falling NAVs and narrowing discounts, at this point in time small-cap trusts are attractively valued from an historical point of view thanks to sustained outflows from the open-ended sector and as a result of a general fall in investors’ risk appetite.
According to the AIC, the sector is trading on a 10 per cent discount and more than 54 per cent of trusts in it with a long enough track record are now trading on a wider discount than their three year average.
Source: The AIC
The major caveat against this argument though is cost – which ironically has also been seen as a positive of backing trusts over funds in the past.
Due to the implications of the Retail Distribution Review (RDR) and the launch of ‘clean’ share classes, open-ended funds now look far more attractive from a fees point of view.
FE data shows the average trust in the IT UK Smaller Companies sector has ongoing charges of 1.28 per cent while the average IA UK Smaller Companies fund has a clean ongoing charges figure (OCF) of 1.03 per cent.
On top of that, a third of small-cap trusts carry a performance fee.
Nevertheless, the likes of Rathbones’ David Coombs and Hawksmoor’s Ben Conway say that if investors can find the right strategy they should always go for an investment trust over a fund for their small-cap exposure.
Conway, for example, thinks that one of major problems is that groups become too greedy and allow their open-ended funds to become too big.
“I completely agree and I think investment trusts are fantastically suited for smaller companies,” Conway said.
However, he points out that investors can’t always expect their closed-ended fund to avoid all liquidity issues as while managers don’t have to deal with inflows, their underlying NAVs can grow substantially over time if their stock picks perform well.
Again, this means top-performing investment trust managers may sometimes have to potentially dilute performance by increasing the number of their holdings.
Therefore, Conway says if investors want a smaller companies fund they can truly “buy, hold and forget about” – they should turn to the recently launched River & Mercantile UK Micro-Cap Investment Trust.
It has a relatively unique design; if the NAV (which currently stands at £54m) were to grow above £100m the board will return all the excess cash to shareholders in the form of capital rather than reinvesting their gains back into the market.
As a result, the trust should always remain below £100m, meaning that its FE Alpha Manager Philip Rodrigs should never have to compromise performance.
“[River & Mercantile Micro Cap Investment Trust] is one of the best examples of purely shareholder-friendly investment trust,” Conway said.
The trust has taken its time to be fully-invested since its launch in December last year and still holds 21 per cent in cash. On top of that, its shares jumped onto a healthy premium at launch due to its innovative structure and its well-respected management team but that premium has since fallen to just 0.79 per cent.
All told, it means the trust is underperforming against the sector since inception.
Performance of manager versus peer group composite during career
Source: FE Analytics
However, as the graph above illustrates, investors are buying a top-performing and highly-rated manager in Rodrigs – who has managed the likes of Investec UK Smaller Companies, Investec UK Alpha and the now closed R&M UK Equity Smaller Companies fund during his career.
Of course, there are many instances where investors are better off in funds than in trusts and it is also true that you simply don’t have the variety of options in the closed-ended universe as you do with unit trusts and OEICs.
But at the same time, there are clear advantages of turning to investment trust land for smaller companies and, in our eyes, the most important one is capacity as why should an investor be punished for picking a good fund only to see its AUM surge and therefore its approach change?
In fact, size and capacity are aspects FE Trustnet will be focusing more and more on and campaigning to make more transparent over the coming months.
