The best small cap funds and investment trusts

10 mins. to read
The best small cap funds and investment trusts

It’s a very exciting time to invest in smaller companies, and Nick Sudbury has picked out some of the funds and trusts that can give investors ready-made exposure.

Small cap stocks are one of the most fertile areas for fund managers to operate in. These sorts of companies don’t attract as much attention from the analysts as their larger brethren, which means that there’s plenty of hidden gems to uncover for those who are willing and able to do the research.

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Adrian Lowcock, Head of Personal Investing at Willis Owen, says that it is a very exciting time for smaller companies, as modern technology enables them to more easily access a larger market without the huge amounts of capital investment that were previously required.

“Valuations of smaller companies are not expensive either, although I do think it is misleading to look at average valuations of small caps, as it is the individual companies that matter.”

The sector was hit hard in the fourth quarter of last year as investors adopted a risk-off approach. When markets are under pressure it is the perceived riskier and less liquid investments like small cap stocks that tend to be the most vulnerable, although there has been a strong recovery in the first part of 2019.

Smaller companies can be very volatile in the short term, and even over a one- or two-year timeframe they can experience sharp ups and downs, but the longer-term performance speaks for itself.

Over the last 25 years, the IA UK Smaller Companies funds sector has generated an average cumulative return of 1,004%, which is well ahead of the 474% produced by the multi-cap UK All Companies funds.The same difference can also be seen with Japanese, European and US funds.

Room to grow

Darius McDermott, MD of FundCalibre, says that smaller companies tend to do better than larger companies over the long term. “This is because they have more room to grow. It is easier for a company with a market capitalisation of £200m to double than one of £50 billion. Also, larger companies tend to grow via merger and acquisition, rather than organically like some smaller companies.”

Whilst interest rates stay low and global growth remains muted, investors are likely to opt for companies that can grow faster than the economy as a whole, such as the small caps. Because of the volatility, the safest way to invest is by drip feeding money in on monthly basis, as this naturally evens out the fluctuations in the market.

Patrick Connolly, a Chartered Financial Planner at Chase de Vere Independent Financial Advisers, says that investing in smaller companies is most suitable for higher risk investors who want the potential of better returns and are willing to accept greater levels of volatility and potentially big short-term losses in order to achieve this.

“Over the longer-term, small companies, which are often dynamic firms, should outperform larger companies that might be at the consolidation stage of their development.”

The problem is that UK domestic stocks still have the overhanging uncertainty of Brexit and this is a bigger concern for smaller companies, which are likely to earn more of their revenue in the UK, and could be badly affected by any weakness in the British economy.

“Those looking to invest in smaller companies should be assuming a time horizon of at least five years and, over this period, with valuations looking attractive and with Brexit issues hopefully having been long resolved, smaller companies could be positioned to perform very well,” notes Connolly.

Open-ended funds

His preferred option is the £894m Liontrust UK Smaller Companies fund, which he describes as a top-quality fund with a strong investment team that focuses on factors such as high recurring income, distribution networks and intangible assets such as brand and culture.

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The managers,Anthony Cross and Julian Fosh,have built a concentrated 66-stock portfolio of which 72% by value is listed on AIM. It is quite expensive with an ongoing charges figure of 1.4%, but this is more than made up for by the excellent performance, as since inception in 1998 it has returned almost twice the sector average with a gain of more than 1,100%.

Lowcock also likes it because it provides investors with access to a differentiated process that concentrates on the importance of the intangible assets of a company.

“This typically leads to a bias towards the less capital-intensive people businesses, such as support services, technology, and media. The size of each holding is influenced by the riskiness of the investment, with the managers paying relatively little attention to the benchmark.”

McDermott prefers the£49.5m LF Tellworth UK Smaller Companies fund despite the fact that it was only launched last November. He says that it is a pure smaller companies fund run by two very experienced and highly regarded managers, Paul Marriage and John Warren.

“They have an outstanding long-term track record investing in smaller companies and this fund is very similar to portfolios they have run before at Cazenove and Schroders. We have high hopes that they can repeat their past success with this new venture.”

Looking at their holdings, the median market cap is £263m, which is much smaller than many of the other funds operating in the sector. This is where they see the best opportunities ahead of some kind of resolution of the Brexit process. 

Global exposure

The majority of smaller companies funds invest in a single region, which means that you would have to hold several of them to get a full international exposure, whereas the Aberdeen Standard Investments Global Smaller Companies fundwould be sufficient in itself. This £1.3bn vehicle has a concentrated 54-stock portfolio that is divided between the US, UK, Japan, Europe, China and elsewhere. Over the last 5 years it has generated a cumulative return of 80.8% compared to the global sector average of 60.5%.

Investment trusts

The analysts at Numis say that over the long term, the UK Smaller Company investment trusts have built up a good track record relative to their open-ended counterparts. This reflects the fact that the closed-ended structure is well suited to this relatively illiquid asset class and allows the fund managers to back their views without having to worry about the trading liquidity of the underlying stocks.

Data from Winterflood Securities reveals that there are 13 UK small cap investment trusts, with the sector trading on a weighted average discount to NAV of 7.8%. The largest are Aberforth Smaller Companies (LON:ASL)(£1.15bn), BlackRock Smaller Companies (LON:BRSC) (£679m), Henderson Smaller Companies (LON:HSL) (£669m), and Standard Life UK Smaller Companies (LON:SLS) (£492m).

There are also three UK micro-cap trusts including Miton UK Micro-Cap (LON:MINI) and R&M UK Micro-Cap (LON:RMMC), as well as six Global Smaller Companies trusts, the largest of which is Smithson (LON:SSON), which was launched last October.

Most of the investment trusts operating in the sector have a growth at a reasonable price (GARP) investment style, whereas Aberforth Smaller Companies and the income focused mandates have a value bias. The other main option is Standard Life UK Smaller Companies, whichhas a high growth methodology.

Last year was a tough one for the sector with the NSCI ex Investment Companies Index falling 15.3%, although all the UK smaller companies trusts managed to outperform it in terms of their share price total returns, helped by a narrowing of the discounts. The asset class has recovered strongly since then, along with the rest of the market, with the index up 8.7% in the first quarter of 2019.

Core holding

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Numis regard Henderson Smaller Companies as an attractive core holding for those who want exposure to small cap stocks.Neil Hermon, the manager, focuses on companies with good growth prospects, sound financial characteristics, and strong management that are trading at a valuation level that does not reflect these strengths.

He has established a strong long-term track record, with NAV total returns of 15.7% per annum since he took over in late 2002 (versus 12.3% p.a. for the NSCI ex Investment Companies Index). The fund also benefits from low fees, with an ongoing charges figure of just 0.41% plus a performance incentive. It is currently trading on a 9% discount and yielding 2.4%.

Herman has put together a well-diversified portfolio consisting of 105 different holdings, with the largest position, Bellway, accounting for 3.2% of the assets. The manager tends to focus on the larger more liquid stocks in his investible universe, and is willing to hold onto the winners, hence the reason that 57% of the portfolio is currently in FTSE 250 mid-cap stocks, with the remainder split between FTSE Small Cap (16%) and AIM (24%).

The largest fund in the sector, Aberforth Smaller Companies, has suffered in recent years due to the fact that its value investment style has been out of favour. This makes the performance look dull relative to the sector average, even over 10 years, although it has still managed to significantly outperform since its inception in 1991. The shares are trading on a 9% discount and yielding 3%.

Other trusts

If you would prefer a higher weighting to shares listed on AIM, you might want to consider BlackRock Smaller Companies, which can invest up to half of the fund in these stocks. Mike Prentis, the manager, has established a strong track record via his quality growth bias, characterised by strong balance sheets and proven management teams. He has put together a diversified portfolio of 133 stocks, with the fund generating a 10-year share price total return of 623%.Prentis has recently announced his retirement and will be replaced by his co-manager, Roland Arnold, who has worked with him for the last 14 years.

Winterflood’s favoured fund in this area is Standard Life UK Smaller Companies, which has been managed by Harry Nimmo since September 2003. Nimmo is one of the most highly regarded managers in the sector and has considerably outperformed his peer group and index over the last 10 years by focusing on quality growth stocks.

The manager invests in strong business franchises that have the potential for considerable earnings growth. He has put together one of the more concentrated portfolios in the peer group with just 54 stocks, of which the top 10 account for 33% of the assets. These include the likes of Dechra Pharmaceuticals, Fevertree Drinks and Gamma Communications.

If you are looking for something a bit different, McDermott suggests the £494m Baillie Gifford Shin Nippon Trust (LON:BGS),which is unusual as it invests in Japanese smaller companies. Over the last 10 years it has returned 817%.

“Shin Nippon means ‘new Japan’ and this trust focuses on emerging or disrupted sectors, where the manager sees innovative growth opportunities. The team are prepared to bide their time while these companies reach their full potential,” he says.


The £1,289m Merian (formerlyOld Mutual) UK Smaller Companies fund has one of the best investment teams in the sector, and they have produced a strong and consistent performance over many years.

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“It is one of the bigger funds operating in this area, which means that the managers invest in larger companies than some of their competitors. Their focus is on investing in good quality businesses and this has enabled them to benefit from IPOs, which has helped to drive the performance in recent times,” explains Patrick Connolly of Chase de Vere. 

Dan Nickols, who has been running the fund since 2004, has put together a 93-stock portfolio that is currently weighted in favour of industrials and financials. Over the last five years it has returned 62% versus a sector average of 41.3%.

In order to be included, companies must first demonstrate one or more of the following characteristics: the ability to grow earnings faster than the market average for an extended period of time; the scope to generate a positive surprise; or the potential to be re-rated relative to the market.

Adrian Lowcock of Willis Owen says that a pragmatic approach is taken to valuation, with various ratios and timescales used depending upon the situation. “This flexible approach allows growth, value and recovery companies to be held, although the portfolio has tended to show a growth bias.”

Fund Facts

Name: Merian UK Smaller Companies
Type: OEIC
Sector: UK Smaller Companies
Total Assets: £1.3bn
Launch Date: February 2001
Current Yield: 0.59%
Ongoing Charges: 1.03%

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