UK smaller companies have outshone the blue-chip index this year, providing a total return of 7.18 per cent compared to the FTSE 100’s loss of 4.35 per cent.
Performance of indices in 2015
Source: FE Analytics
Global-facing large-caps have been badly hit year-to-date as a result of several macroeconomic headwinds including China’s slowdown, the collapse in commodity prices and nerves surrounding the rate rise from the Federal Reserve.
Smaller companies, however, are far more domestically-orientated and have thrived off of the UK’s strong economy. In fact, data from the Association of Investment Companies shows three smaller company sectors feature in the top five top-performing investment trust sectors this year, with the UK Smaller Companies being one of them.
Despite this, some more cautious investors are bearish on holding funds that contain smaller stocks because of potential issues surrounding illiquidity and a level of unpredictability that comes with buying into newer companies.
Will smaller companies continue to do well as we head into the New Year or should investors who are already nervous remain invested in large-caps instead? 
Mark Dampier (pictured), head of research at Hargreaves Lansdown, currently holds Marlborough Nano Cap Growth, Marlborough UK Micro Cap Growth and Marlborough Multi Cap Income, which has a 35 per cent weighting in small-caps, in his personal ISA and believes small-cap remain a stellar long-term investment.
“I honestly think that small-cap is a place to hold for the longer term. You can buy it in the income sector now so why wouldn’t you? The trouble with very large caps is that the FTSE 100 is dominated by mining industries, it’s probably much better-researched compared to smaller indices and it’s very driven by macro events, whereas small-cap and mid-cap are less exposed to that area,” he explained.
“I think small-cap looks good and I would point out that if you’re younger and investing into ISAs or pensions, you’d be completely mad not to have a couple of good small-cap funds in there.”
Dampier also holds JO Hambro Equity Income and notes that managers Clive Beagles and James Lowen now hold their largest ever allocation to small-caps within the fund at 15.7 per cent.
However, many investors are worried about next years’ in-out referendum on the UK’s membership of the European Union and the impact this could have on domestically-focused UK companies if Britain leaves Europe.
“It might cause some short-term volatility,” Dampier said. “Personally my belief is that people will vote to stay in because people aren’t very good at voting for change, especially if it’s a change they can’t really work out.”
Simon Evan-Cook, senior investment manager at Premier, also remains comfortable investing in the UK smaller companies sector as we head into 2016 and believes there are particularly attractive valuations towards the smaller end of the small-cap market.
However, he warns that if there is a bear market sell-off as a result of macro headwinds including the referendum and a UK rate rise, domestic small-caps will be hit particularly hard.
“Small-caps could do anything from provide very handsome returns to becoming a downright nasty investment space. It all depends what happens with events that are well outside our control or our ability to foresee them,” he warned.
“I still think ultimately that the UK smaller companies sector is a great place to invest because it provides growth potential and also the potential for very good active managers to grasp opportunities from it being a less efficient market.”
“It’s a great place to hold over the long term, but any given year could be a bad year – you just have to be ready for that eventuality and spread your risks so you’re not just putting all your apples in that one small-cap basket.”
Royal London Cautious Managed manager Trevor Greetham and Royal London economist Ian Kernohan say earnings revision data for the UK currently looks “terrible”, although this is mostly related to the global-facing nature of large-caps in the region.
“What would really help would be if commodity prices turn upwards, I think then we could see the FTSE’s performance improve,” Greetham said.
“We think the UK economy is in pretty good shape actually, although we think that mid-caps look quite good rather than small-caps, per se. The only thing on my mind that I’m a little bit cautious on is the housing market.”
The manager believes that there has been a number of headwinds thrown at the UK housing market recently including stamp duty increases, which could take their toll as we head into the new year.
“Domestically-exposed stocks in the UK are fairly okay. We do think the Bank of England will raise rates in the second half of the year subject to Brexit risk,” Kernohan added.
“If the Brexit referendum has a major impact on the economy in the sense of companies then it will be difficult justifying buying into that area of the market. But the basic domestic picture looks okay and UK households have been one of the big beneficiaries from low energy prices, it’s just that commodity exposure at the larger end that keeps us cautious.”
Alan Custis, head of UK equities at Lazard Asset Management, agrees that the performance of UK small-caps in 2016 will depend on the outcome of the EU referendum. Regardless of the result though, he believes that there is likely to be short-term volatility in the UK smaller companies area of the market as the referendum approaches.
“There’s a big cohort of small-cap funds, whether it’s income small-cap or just pure small-cap that will continue to be supportive of the market. There is no reason why it couldn’t continue to do well, I don’t think there will be a huge flight of capital because, in this day and age, there aren’t funds that say, ‘I was double-weight small-cap and now I’m going to go underweight small-cap’ because everyone seems to be a specialist, so they’ll keep supporting their pot of capital for as long as they can.”
“The big asset allocations which may have been taken 10 years ago just don’t seem to happen now. Maybe small-caps could underperform a little bit.”
Michael Clark, manager of a number of funds at Fidelity including Moneybuilder Dividend, says that small-caps are a “mixed bag” and, while some of them are likely to do well, others could be subject to significant downside risk.
“I’m not really a big one for small-caps [in Fidelity Moneybuilder Dividend] at the moment personally because I think some of the larger and mid-sized companies fit much better,” he said. “They provide much better returns, particularly in the context of what we’re trying to do within the fund.”
“Small-caps also have a liquidity problem and that’s an issue. We’ll have to see. At the moment I’m certainly not seeing very small companies as providing us with a lot of opportunity.”
