While the FTSE All Share has failed to make any significant gains since its peak on 22 May of last year, the average IMA UK Smaller Companies fund has added 22.87 percentage points of outperformance.
The funds have also been significantly less volatile in a period when markets have been haunted by fears of an end to quantitative easing and a slowdown in emerging nations.
Performance of sector and index over 1yr
Source: FE Analytics
Over the past year the FTSE All Share is up 11.25 per cent, and just 0.12 per cent up from its 22 May value.
In the intervening time it has briefly poked its head above that number but has struggled to make headway; this is not the case for smaller companies funds.
Our data shows that they are up 31.53 per cent for the year and up 22.87 per cent since the 22 May peak.
Investors may expect small cap funds to outperform in a rally, but the fact they have managed to do so while the overall market has remained flat is notable.
Also remarkable is the lack of volatility: the FTSE All Share has a volatility score of 11.01 per cent over the past year compared with just 7.01 per cent from the average IMA UK Smaller Companies fund.
Smaller Companies funds proved more resilient to the original dip in May, and fell less when markets retreated later in the year. In November and December they rose while the All Share sank.
They are also up in the year to date, making 2.4 per cent while the FTSE All Share has lost 1.82 per cent.
Performance of index and sector in 2014
Source: FE Analytics
One of the key factors seems to be the relative lack of reliance on emerging markets. The sell-off in May was particularly harsh on those regions as it saw funds withdrawn in anticipation of higher yields in developed markets.
This hurt large cap companies with a global footprint – those that are more exposed to emerging market demand.
It is possible that this is a temporary trend, but some managers believe that the nature of the market is changing, which could lead to this outperformance continuing.
FE Alpha Manager Gervais Williams says we are witnessing a multi-decade shift in market dynamics that investors have been slow to pick up on. He points out that the world saw a credit boom following the deregulation of the early 1980s, which resulted in soaring asset prices and the popularity of index-based, high beta strategies.
However, this era is at an end, and with trading volumes decreasing and emerging markets slowing down, a new style of investing is necessary, he explains.
“There are significant changes in market trends and patterns,” he said. “The deregulation since 1985 has meant that demand for assets increased, which has led to changing trends in how people invest.”
“It has been advantageous to invest in assets that move faster than others, such as emerging markets, but we think different trends are becoming apparent.”
During the multi-decade trend, investors chased high-beta sectors such as commodities, emerging markets and financials and were able to do so again and again because of cheap credit pumping up asset prices, on Williams’ reading.
Both price/earnings multiples and trading volumes boomed during the period of credit expansion from 2000 to 2007 in particular, but have sunk back to much more subdued levels.
Lower trading volumes are likely to be a feature of the market for years to come, with investors more likely to be looking for buy and hold stocks.
“We don’t expect the changes to happen very quickly. We expect this to be the way of things for at least a couple of decades,” he said.
Williams adds that the fallout from the credit boom and bust of high debt and sluggish economic growth means that investors will increasingly turn to smaller companies for ideas.
“Smaller companies can grow when the economy isn’t strong,” Williams said. “Small companies can take market share from large companies and can move around and take advantage of new markets more quickly,” he said.
Smaller Companies funds have more than doubled the returns of the FTSE All Share over the past five years, according to our data.
Performance of index and sector over 5yrs
Source: FE Analytics
Investors may be inclined to see their recent outperformance in this light: as a continuation of a strong tendency to outperform in rising markets.
However, our data suggests that the funds have managed to outperform even after the high-beta rally has come to an end.
Williams says that we are now entering a new type of market which will favour smaller companies for decades to come.
“A lot of people think the best of smaller companies has gone, but we think we are seeing a new trend at the end of a credit boom and they will continue to outperform,” he said.
