Trusts in the UK smaller companies sector have enjoyed a cracking year, with average share price gains of 44%.
This compares with gains of 32% from the FTSE Small Cap index and 43% from the Hoare Govett Smaller Companies (HGSC) index, which is the more popular trust benchmark.
Despite its good run, the sector's average discount is 16% compared with 9% in the UK growth sector. This might imply that, despite their greatly superior long-term returns, smaller company trusts have a less than rosy future. However, trust managers disagree.
For example, gearing on Aberforth Smaller Companies Trust, the sector giant, is well above its long-term average, indicating that its value-oriented managers are confident that smaller companies are cheap and have plenty of room to grow in value.
Standard Life UK Smaller Companies Trust has trounced its sector peers since Harry Nimmo took charge in 2003.
He focuses on companies with strong balance sheets and resilient business models. Overseas exposure accounts for around half of his portfolio's combined earnings.
Nimmo says smaller companies usually do well for 18 months after a turn in the market, which explains why his trust is still 11% geared.
Gartmore Growth Opportunities has the best three-year performance figures, which were boosted by a large put option on the FTSE 100 index, which it exercised in October 2008.
Manager Gervais Williams says smaller companies are undeservedly under-owned by institutional investors, who are ignoring superior growth potential derived from starting from a smaller base.
Added attractions include the dividend growth prospects of some smaller companies, the increased potential for rewarding takeovers when sterling is weak and the fantastic scope for good sharepickers in such a large universe.
Spotlight on Throgmorton Trust
Throgmorton trust is very different to its peers. It has a traditional long-only portfolio managed by Mike Prentis, similar to its stablemate BlackRock Smaller Companies, which Prentis also manages.
But Throgmorton also has up to 30% in a contracts for difference (CFD) portfolio run by successful hedge fund manager Richard Plackett.
Prentis expects smaller companies to continue to outperform, as the rise in their share prices has been justified by the recovery in profits. He is keen on companies focused on faster-growing regions. Half of his revenue comes from Asia and North America.
He concentrates on around 150 promising holdings in a universe of more than 1,500 companies. "Many are leaders in their sectors and managed to cut costs and grow their market share in the downturn," he says.
"Around a fifth is in companies capitalised at less than £100 million, as they are under-researched and can be very exciting over the long term."
Prentis says the CFD portfolio added to returns in last year's rapidly rising market but should do even better in more stable conditions, as it is easier to make money from taking short as well as long positions in underlying securities.
It should also prove its worth if markets plummet, as it can reduce Throgmorton's net exposure to 70%.
Jonathan Ruck Keene, head of investment companies at BlackRock, says Throgmorton's unique structure is attracting a following among private client stockbrokers.
However, they dislike its commitment to regularly offer to buy back shares at a discount well below the average for the sector, as they feel obliged to subscribe.
The trust proposes to suspend these tenders following a final offer of up to 25% for investors who want to get out.
This article was originally published in Money Observer - Moneywise's sister publication - in June 2010