Investors in UK small-caps have enjoyed the most relative outperformance to large-caps globally over the last five years, according to the latest FE Trustnet study. 
Over a longer period of time, small caps are widely expected to outperform larger companies, as they are able to grow at a faster rate, providing higher returns to investors.
Simon Evan-Cook (pictured), senior investment manager at Premier Asset Management, said: “When you look at the makeup of large cap markets they tend to be companies that are ex growth – that have grown as large as they are going to get and simply can’t keep doubling in size every year in the way a small company can.”
However, when thinking of small-caps, most UK investors will tend to focus on domestic stocks rather smaller companies elsewhere around the world.
Therefore, in this study, we wanted to analyse how well UK small-caps have performed (relative to FTSE 100 stocks) against smaller companies around the world (again, relative to their own large-cap indices. The short answer is: very well.
Smaller companies are more domestic-facing and, more susceptible to local economy changes, and over the last five years, UK small caps in particular have performed well, as the UK economy has strengthened.
With market conditions buoyant, particularly in 2012 and 2013, investors were more willing to take on extra risk with investments in the small cap space, spicing up their portfolios and boosting the value of smaller companies in the process.
As the table below shows, this led to the FTSE Small Cap index outperforming its larger rival FTSE 100 by some 41.67 percentage points over the past five years.
Performance of small cap and large cap indices over 3, 5 and 10yrs
Source: FE Analytics *Small-cap outperformance measured in percentage points
This was the largest relative outperformance by any of the regions studied (15.24 percentage points), and was 29.55 percentage points ahead of the average of the four other regions.
Parmenion investment manager Stephen Lennon said: “As these numbers indicate there is a premium that can be captured from smaller companies (in the UK).”
However, despite this outperformance, the small cap index is now at one of the widest discounts to the FTSE 100 in history, having suffered heavily in the wake of the EU referendum result.
Performance of indices in 2016
Source: FE Analytics
He added: “From a valuation point of view they [small caps] look quite attractive”.
“For investors that can tolerate the volatility of small cap and for those that are going to be holding their money for quite a long time the data clearly shows there is an additional risk premium that can be captured.”
However, this is not the case in all areas, our study shows that US smaller companies have underperformed against the S&P 500 index over three and five years.
Premier’s Evan-Cook said: “For me, the bigger question is why this [small cap underperformance] has happened in the US as I think large cap outperformance is the bigger anomaly not the other way around”.
While small caps have only marginally underperformed their larger rivals (60 basis points over three years and 1.2 percentage points over five years) this is an outlier compared to the rest of the regions analysed, and Evan-Cook suggests this is due to two factors.
“US small caps were doing exceptionally well up until three or four years ago and I think there’s been a period of profit taking since then. They got to a point where they were simply too highly rated and too expensive so there’s been a bit of catch up from large-caps there.”
“The other thing I think is that it’s just within the nature of what is in the US large cap-market. You look at what’s been doing particularly well and they are the likes of Google, Microsoft, Apple and Amazon – these tech giants which dominate not just US markets but global markets.”
He says the “quasi-monopoly” companies dominate the US index and that other markets, such as Europe and (to a lesser extent) Asia, don’t have these truly global companies taking up such a large weighting of their indices.
Performance of indices over 5yrs
Source: FE Analytics
The above table backs up his point, with the MSCI USA Large Growth index, of which Amazon, Google owner Alphabet, Facebook and Apple make up almost 19 per cent, outperforming the MSCI USA, where they have a much lower weighting, by 15.5 percentage points over five years.
Parmenion’s Lennon agrees that these type of companies are responsible for the large cap outperformance, adding that they are beginning to be used as safe havens for times of uncertainty.
“The American market is seen as a bit of a safe haven play so what you tend to find is that in the more volatile and more uncertain market you will see the dollar and the S&P do well.”
“If you were a foreign investor needing to buy equity but looking for somewhere safe you’re going to go somewhere like large cap American companies.”
Additionally, Whitechurch’s Ben Willis says the US ETF market should not be overlooked as an important factor in US large cap outperformance.
“The ETF market in the US is absolutely massive with most of these tracking the large cap S&P 500,” he said.
The largest ETF is the SDPR S&P 500 ETF, which is worth just shy of $200bn, and with many of the top tech companies mentioned above eating up a large weighting of the index, they benefit more from these investments.
“This has much more of an influence on the market than in the UK and Europe respectively, where the ETF markets are much, much smaller in comparison,” Willis said.
Looking further afield, over a 10 year period, emerging market small caps are the clear winner, relatively outperforming their large cap rivals by 52.63 percentage points.
While over five years, emerging market small caps have been relatively lacklustre, this jumps at the 10 year period, due somewhat to the bull market that took place during the early 2000’s.
Parmenion’s Lennon said: “Emerging markets performed incredibly well in the early 2000’s and so the 10 year data has captured a lot of that real economic boom, and if you have very strong economic growth then small and medium cap is where you want to be as they are more domestically exposed.”
Performance of indices over 10yrs
Source: FE Analytics
The above graph shows the end of the bull market in the early 2000’s and the outperformance in aftermath of the financial crisis in 2008.
However, Lennon says “what you’ve seen over the last six years there’s been a bit of a reversal of that, where emerging markets has massively underperformed the developed world - so you’ve seen a capital flight to developed markets and the slowing of emerging market growth.”
But emerging markets have taken off of late, with many believing the area is line for a resurgence, and if this confidence towards the developing world continues, Lennon says it should mean wider small-cap outperformance in the future.
