Fund briefing: UK smaller companies

Over the past year, the average portfolio focused on these areas has enjoyed bumper double-digit returns, with some up more than 30%, according to Morningstar data to 31 October 2015.

The success enjoyed by IA UK Smaller Companies and IA European Smaller Companies contrasts with sectors such as Asia Pacific excluding Japan and Global Emerging Markets, in which many investors have lost substantial amounts of money.

Darius McDermott, managing director of Chelsea Financial Services, attributes the strong performance to a number of factors, with UK-focused funds benefiting from a domestic focus at a time when our economy has been stronger than many around the world.

“There are also fewer commodities companies in the smaller companies space – and these have been hit very hard recently, as well as some larger companies with emerging market exposure,” he says. “Not investing in these companies has helped performance.”

To be included in the IA UK Smaller Companies sector, funds must invest at least 80% of their assets in UK equities of companies forming the bottom 10% by market capitalisation.The North American and European Smaller Companies sectors have similar requirements.

Financial advisers regularly use such funds when they are putting together overall portfolios for their clients. Alex Bland, investment manager at Beacon Wealth Management, is one who favours the sector.

“We like to complement our overall UK equity exposure with small caps,” he says. “They tend to provide a good return for reasonably low volatility and always tend to be the first to benefit from any uptick in market trends or recovery cycle.”

There are two main reasons for considering an investment in one of these sectors, according to Justin Modray, founder of Candid Financial Advice: diversification and the fact that they tend to enjoy better longer- term returns.

“It’s quite common for UK investors to own tracker funds that follow indices such as the FTSE 100 in their overall portfolio,” he says. “These give them a very high bias towards larger companies, many of which are in a handful of sectors, such as energy and mining.”

Such areas may not always be attractive propositions, he argues, which is why it can make sense for most balanced investors to have at least some exposure to smaller companies in order to hedge out this larger company exposure.

“The caveat is that smaller companies tend to be more volatile,” he adds. “When things do well, you might make more money but if markets fall, you tend to find smaller companies can go down further, so it’s important not to put too much in if you’re afraid of taking a risk.”

So why do smaller companies offer more potential? According to Mark Dampier, head of research at Hargreaves Lansdown, the fact these stocks are only followed by a few analysts presents opportunities for skilled fund managers to spot opportunities.

“Unlike larger companies such as Tesco or Vodafone, which might have dozens of analysts poring over their accounts, smaller companies tend to be under-researched,” he explains.

“Some will blossom into the giants of tomorrow, but others will struggle or fail altogether.”

Therefore, selecting the winners from the UK’s ever-expanding pool of smaller companies is not easy, which means relatively few fund managers can be relied upon to deliver consistently strong returns.

It’s also worth noting that not all smaller companies funds are the same – some invest right down the scale in micro-caps, while others look at the bigger smaller companies and smaller medium-sized companies.

The key when you’re selecting a smaller companies fund manager is deciding if they have experience and a proven track record of success in different environments, according to Patrick Connolly, a certified financial planner with financial adviser Chase de Vere.

“You need managers who can really get under the skin of companies to understand how they work and assess their future plans and prospects,’” he said. “The best can uncover fantastic companies with great growth prospects that have been overlooked by others.”

Of course, the amount you should invest in such funds depends how much exposure you already have, as most people will have some investments in this area by virtue of the broad-based equity funds they own, points out Connolly.

“If that’s the case, many investors won’t necessarily need any further investments in smaller companies funds,” he said. “If they want specific smaller company exposure, then it probably makes sense to start with UK smaller companies, although other parts of the world also still have strong growth potential.”

Fund to watch: Schroder Dynamic UK Smaller Companies

A relative handful of UK smaller companies funds make it into Hargreaves Lansdown’s coveted Wealth 150 list of favoured portfolios but one that has is Schroder Dynamic UK Smaller Companies, run by Paul Marriage and John Warren.

Mark Dampier, head of research at Hargreaves Lansdown, says the fund was selected because the management team boasted plenty of experience, a disciplined approach to investing, and a history of outperformance.

“We have long been supporters of the higher-risk UK smaller company space and the sector contains many high calibre individuals,” he says. “The managers remain incentivised to perform and we believe they are capable of driving long-term growth.”

The fund, which aims to provide capital growth, will have at least 80% invested in shares of UK companies that are in the bottom 10% of the UK stockmarket at the time the fund purchases them. It doesn’t have any bias to particular industries.

At present, industrials is the sector with the largest share of assets (39.3%), followed by consumer goods (13%), technology (12.4%) and consumer services (12.2%). Other sectors represented, each of which have a share of less than 10%, include financials
and healthcare.

The fund’s 10 largest holdings account for 32.6% of its assets and include names such as logistics company Wincanton; Johnson Service Group, which supplies textile related services; and Treatt, a supplier of flavour and fragrance ingredients.