UK smaller company funds back in fashion

Smaller companies have proved fairly unfashionable among investors in recent times, with largely good reason. Over the past decade more money has flowed out of the Investment Managers Association UK Smaller Companies sector than in, as investors seek safety or are attracted by the exciting growth opportunities overseas from funds investing in the likes of China, Brazil, India and Russia.

Looking at the FTSE Small Cap Index, investors taking cash out of the sector look to have made a wise decision. The Small Cap Index has significantly underperformed compared to the FTSE 100 over the past decade. On top of that, returns from smaller companies tend to be more volatile than larger companies. The greater risk alone is enough to scare off wary investors.

And yet, when you look at the returns from actively managed funds in the IMA's UK Smaller Companies sector over ten years, it's clear that a sizeable number of managers have delivered returns that have outperformed the FTSE 100. In fact, of the 36 funds in the sector, 28 have produced better returns than the Footsie over the past 10 years.

It raises the age-old question of active against passive. Do you choose a passive fund – such as an indextracker – which critics say can only ever produce average returns? Or do you seek out an active manager in the hope of outperforming the index?

Giles Hargreave, CEO of stockbroking and fund management firm Hargreave Hale and manager of the Marlborough Special Situations Fund, suggests that investors are missing out by not considering smaller company fund managers. "The debate regarding the value that active fund managers deliver to investors relative to their fees has overlooked smaller company fund managers, many of whom have done as they set out to do and delivered strong returns for their investors before and after fees," he says.

"Smaller companies are under- researched, offering the opportunity for strong growth, although, yes, they are also more volatile than larger companies in terms of the consistency of those returns. But, if you are investing over the longer-term then a good fund manager should be able to prove that they can deliver value."

The risk for smaller company fund managers is obviously backing the wrong stock. But pick the right one and growth can be phenomenal. Standard Life's UK Smaller Companies fund – managed by Harry Nimmo – has climbed 58 per cent over the past year., for instance. But rather than punting little-known outfits, it holds stakes in what have become hugely successful brands or members of the Footsie, such as online retailer ASOS or financial services firm Hargreaves Lansdown.

Adrian Lowcock, senior investment adviser at Bestinvest is a fan of the fund and also recommends the Old Mutual UK Select Smaller Companies fund. "There is a balance of arguments for smaller companies, however I am more positive on the sector for investors," he says. "Basically there are plenty of niche players and new companies that enter the stock market at this level and provide investors with huge potentials for growth. Lets face it, many large multinationals started out as small companies in one form or another.

He points out that as well as the potential for growth, there's the chance that a successful smaller company will be snapped up by a bigger company, often at a strong premium to the share prices. "But the issue for me is separating out the wheat from the chaff," Lowcock says. "It is imperative to pick out the winners from the losers and in this I strongly believe an active manager can add value."

Martin Bamford, financial planner with Informed Choice, says smaller companies can offer a good contrast to investing in large firms. "Smaller companies give investors access to a more reflective picture of the UK economy, as most of the larger UK firms get their profits from overseas business," he says. "Funds in the UK Smaller Companies sector can make a great addition to a well diversified portfolio, actually reducing overall levels of risk by moving away from full exposure to large companies."

Danny Cox, investment manager at Hargreaves Lansdown, resists the temptation to tip the Standard Life fund that invests in his firm. Instead, like Lowock, he picks the Old Mutual UK Select Smaller Companies as well as Marlborough Special Situations. "The international nature of many UK smaller companies creates opportunities to gain exposure to more dynamic areas of growth such as chemicals as well as companies with global exposure in the engineering sector," he says.

However, he warns that while smaller companies are more able to take opportunities quickly than larger companies and consequently have a greater prospect for growth,by their very nature, they are more volatile than the blue chips.

"If you combined new money coming in to the sector, with small caps out-performing the FSTE 100 and the out-performance of the top funds, this is a compelling investment story," claims Giles Hargreave. "Why wouldn't you want to capture those returns? Why wouldn't you invest? This is why small cap funds should always be in your portfolio," he says.

"If you have a long-term objective to grow your invested savings then you should consider investing in smaller companies, and you should consider drip-feeding your money in to an investment pot over time to provide the best possible outcome," is Hargreave's advice.