For two decades, smaller companies have strongly outperformed the FTSE 100, mirroring the pattern of mid-caps. But recently small-caps have begun to lag mid-caps, suggesting underlying investor concerns. While the uncertainty of Brexit might pass, the challenges of Woodford and MiFID II look here to stay. Small-cap liquidity seems to be drying-up, as investor fears combine with regulatory change. Risk is rising, as research coverage fades. With low levels of trade in many of the stocks, the sector is starting to look more like private equity. 
The UK stock market is now almost two years into the MiFID II experiment, which sharply cut equity research budgets. The cost burden moved from clients to management groups, and commission fell, putting downward fee pressure on investment banks and stockbrokers. Fund managers negotiated much tougher terms, and City analysts found that much of their research output was simply not valued. In the past, new issues and fundraising would have boosted fees. But, with few IPOs this year, there has been little opportunity for the City to offset the loss of research revenue.
MiFID regulation has fundamentally undermined the business model of smaller company stockbrokers, moving them to focus on covering only their own corporate clients. This means an increasing proportion of smaller company research is inherently flawed, conflicted by fees from corporate clients. This brings a bias towards favourable comment, when a sell recommendation could jeopardise the corporate relationship. Much small-cap research now looks much more like promotional investor relations material than critical analysis.
This drop in research quality should give more opportunity for investing institutions to fill the gap, and profit. But dealing can be difficult for anything other than very small funds. Even where investors identify an opportunity in an undervalued business, it may not be easy to buy enough stock to make the work worthwhile. And, the Financial Conduct Authority is concerned about liquidity risks when open-ended funds hold large positions in stocks that trade less. Private investors may fear that less professional research into smaller companies makes questionable accounting and stock market blow-ups more likely.
In recent years, the FTSE Mid 250 has outperformed the FTSE 100, reflecting the greater growth prospects and M&A of medium-sized businesses compared with the largest mega-cap FTSE100 companies. Until 2018, smaller companies had shared in this outperformance. The divergence since then is marked, with smaller companies lagging mid-cap by almost 10 per cent over 12 months.
Added to the regulatory problems, the increasing emphasis on ESG (environmental, social & governance) factors can be challenging in small-cap. Investing institutions are increasingly focused on new metrics for sustainability, which pose a bigger reporting burden on smaller companies. Governance has historically been weaker at the smaller end of the stock market, with typically less board independence and overall reduced transparency. Previously, investors tolerated the weaker governance if smaller companies offered better growth or higher dividend yields. But the pressure now to be seen to demonstrate good stewardship has made institutional investors less tolerant of poor governance. With this additional burden of research, active investment managers including ESG in their work may simply decide they need to be focused on bigger, more compliant businesses.
Small-cap investors pin their hopes for recovery on resolution of UK trade relations, bringing back foreign investors. And, if Brexit encourages import substitution, many smaller companies will benefit. But investors may prefer to use mid-cap to capture this opportunity. Mid-cap appears to be in the sweet spot in terms of offering liquidity along with growth. But, institutional investors must demonstrate a robust and independent liquidity management process to capture this opportunity. This is easier to achieve in investment firms with capacity limits, allowing them to control exposures and reduce individual company dealing risks.
Smaller companies have faced challenges before, but the dynamism of the sector has always made investors return. But something more permanent may be happening now. If investor interest continues to migrate up to mid-cap, a wider performance gap may open up.
Colin McLean is managing director at SVM Asset Management. The views expressed above are his own and should not be taken as investment advice.