Funds within the IA UK Smaller Companies sector had been some of the main beneficiaries during the recovery from the market lows of the 2008 financial crisis.
Due to improving economic conditions and a growing appetite for risk, the IA UK Smaller Companies sector was the best performing peer group in the open-ended universe between March 2009 and March 2014 with average returns of 229.62 per cent.
As a point of comparison, the FTSE 100 returned 100 percentage points less over that time.
Performance of sector versus index between Mar 2009 and Mar 2014
Source: FE Analytics
However, investors will be aware that it has been a very different story over the past 12 months.
Various explanations have been given for the poor performance of smaller companies since March last year, such as an uncertain macroeconomic environment, the possibility of interest rate rises and redemptions from notable UK multi-cap funds.
Whatever the reason, there have been sustained outflows from the open-ended sector over the past 12 months while small-cap trusts have seen significant discount widening.
Though there is a hotly contested election on the horizon, Dampier says now is a good opportunity to take a look at the bombed-out sector as it has fallen victim to some large-scale indiscriminate selling.
“Small-caps are going through a torrid time at the moment,” Dampier (pictured) said.
“No one seems to want them, and we’re seeing them being dumped left, right and centre. They were on a tremendously good run [until February last year], but I think there’s a lot of momentum players in the market which are driving the underperformance.”
According to FE Analytics, the average fund in the IA UK Smaller Companies fund has lost 1.63 per cent over the last year. While doesn’t seem too disastrous, large-caps have posted double-digit gains over that period which suggests that investors have preferred less risky exposure to the stock market.
Performance of sector and index over 1yr
Source: FE Analytics
Certain funds have been hit very hard by the poor market backdrop. The likes of CF Miton UK Smaller Companies, Schroder UK Dynamic Smaller Companies and Investec UK Smaller Companies have all lost more than 8 per cent over 12 months.
On top of that, the sector has seen net outflows in each of the last nine months, according to the Investment Association. All in all, £766m has been redeemed over that time.
While history has shown the sector is a good hunting ground for growth investors, the consensual view is that small-caps will continue to struggle due to their sensitivity to wider market movements.
Experts have warned that, with the UK heading towards one of the most uncertain general elections in generations on the horizon, the FTSE All Share will be subject to increased volatility and smaller companies will likely be the most affected.
“What has probably happened is that a number of asset allocators, myself included, are running a global portfolio and they’re looking at the upcoming election,” Miton’s Nick Greenwood said.
“There’s lots of concern over whether we’re going to pull out of Europe and that might mean the sterling will become weak. Therefore investors probably want to be trimming their UK exposure, and the small cap sub-sector is an area where you would make a cut.”
On top of that, the Aviva Investors Multi-Manager Survey – which polled managers representing £2trn of assets under management – showed the large majority of professional investors expect smaller companies to continue to struggle.
The survey revealed that 53 per cent of managers expect large-caps to deliver the best performance in 2015, while just 6 per cent expect small-caps to deliver the greatest performance over the same period.
Given that relative and absolute underperformance, negative sentiment and the sustained selling, Dampier says investors should be taking a closer look at UK small-caps.
“They’re unloved, unwanted and unfashionable at the moment. When they bounce back I don’t know, but historically they’ve come back 30 or 40 per cent very quickly. It’s proven a good accumulation opportunity in the past,” Dampier said.
The IA UK Smaller Companies sector is home to 52 funds and one of the best rated is FE Alpha Managers Philip Rodrigs and Daniel Hanbury’s £470m R&M UK Equity Smaller Companies fund – which has five FE Crowns and is a member of Square Mile’s Academy of Funds.
Rodrigs took charge of the fund last year after managing the top-performing Investec UK Smaller Companies since June 2006. Prior to Rodrigs, the fund was solely managed by fellow former Investec employee Hanbury.
According to FE Analytics, R&M UK Equity Smaller Companies has been the sixth best performing portfolio in the sector since its launch in November 2006 with returns of 144.85 per cent, beating its Numis Smaller Companies ex IT benchmark by more than 40 percentage points in the process.
Performance of fund versus sector and index since Nov 2006
Source: FE Analytics
The fund has turned in top quartile returns in each of the last three calendar years and the team at Square Mile – thanks to the R&M’s sophisticated quantitative system which categorises shares by their growth, recovery, asset backed and quality characteristics – think it will continue to outperform.
“The quantitative screen clearly helps to sift and highlight investment ideas in a large universe,” Square Mile said.
“However, this only gets you so far and both Rodrigs and Hanbury have proved themselves very skilful and adept investors over time.”
“We believe that Hanbury has the experience and temperament required in a good fund manager and Rodrigs has already built up an impressive reputation in uncovering rapidly growing businesses that generate impressive returns for investors; together this is an exciting pairing.”
The fund has an ongoing charges figure (OCF) of 0.93 per cent.
However, as UK smaller companies have fallen so out of favour, Dampier thinks there are more opportunities in the closed-ended sector.
“We’re seeing bigger and bigger discounts,” Dampier said. “Buying a trust on a discount gives you a double whammy. Even some of the small cap income trusts have gone onto 3 or 4 per cent discounts and I can’t really understand why.”
“There’s still no yield out there and the pension reforms look to be positive for equity income more generally, but they’ve suffered.”
FE Analytics shows the IT UK Smaller Companies sector has underperformed its open-ended counterpart over the past 12 months as it has lost close to 3 per cent, thanks largely to widening discounts.
Source: The AIC
According to data from the AIC, 12 out of the 13 trusts in the sector with a long enough track record are now trading on wider discounts than their one-year average while 10 of them – such as Aberforth Smaller Companies and Dunedin Smaller Companies – are trading on double-digit discounts.
The likes of Hawksmoor’s Ben Conway have been upping their exposure to small-cap trusts due to that discount value on offer and, in the next article today, FE Trustnet will ask the experts which closed-ended smaller companies funds they would recommend for long-term investors.