Smaller-cap stocks are at last returning to favour. Perhaps this is because the FTSE 100 now offers poor value. But the widening gap in the performance between small companies and the FTSE 100 has been a cause of considerable concern. In the US, where the penetration achieved by tracker funds is considerably greater than here, the underperformance of smaller companies has continued for several years. If the same divide remains here, we could see some of our best known names consigned to also rans. For the time being, though, we have seen both the 250 and Small Cap indices move into new high ground.
The active versus passive management argument has never been greater. The spat (if that is the right word) between Perpetual's Roger Cornick and Virgin's Richard Branson was well reported. In truth, active fund managers are feeling rather embattled at the moment. Not only is it extremely difficult to beat an index where there are no expenses and which remains fully invested at a time when share prices have done nothing but rise, but the flow of funds into vehicles designed expressly to track that index creates a demand which results in outperformance.
The problem is not confined to the retail market. The UK's leading pension fund managers – the big four, as they are known – have been steadily losing business to smaller boutiques. While SocGen Asset Management's Nicola Horlick has hardly had time to steal the odd mandate or two, it does go some way to explaining the attractions of setting up a new pension fund management operation when you learn that, since 1993, the big four's share of segregated schemes has fallen by 15 per cent to 38 per cent of the total.
Part of the reason for losing ground is that their performance has failed to sparkle in recent years. Trustees are more canny, diverting ever bigger proportions of their portfolios into index-tracking funds, a move justified by cost as well as performance.
Of course, active managers will be bailed out by a market setback. But Warren Buffett, in his letter to Berkeley Hathaway shareholders, announced that US stocks are not necessarily overvalued. Mind you, this view has not stopped him diversifying his portfolio into bonds and silver – a case of hedging both ends of the inflation equation if ever I saw one.
If the market is not too high, why bother with second-liners? The answer has to be total return. It is now very difficult to achieve much in the way of dividend income from the UK's biggest companies, yet there are plenty of well known smaller firms giving yields greater than inflation, even after knocking off the tax that is becoming increasingly difficult to reclaim. If this turns out to be a correct strategy, then once again it will favour the smaller managers which can be more nimble in less liquid stocks.
Supporting bigger companies has always been a popular pastime for private-client brokers. The Aunt Agathas of this world like to own shares in companies they have heard of and visit, like Marks & Spencer. Stockbrokers themselves, on the other hand, often feel that it is the smaller companies that will deliver the biggest rewards. Needless to say, this has not resulted in superior performance for many portfolios in the last few years, leading to a return to the "you never got fired for buying IBM" syndrome.
When you look at the ground IBM has lost recently, you might wonder whether the "big is beautiful" argument should be adopted when it comes to constructing investment portfolios.
Personally, I fear that the die is now cast and smaller-cap shares are likely to enjoy relatively brief attention while managers rebalance their portfolios or seek value following a market surge. Of course, when we all start drawing our pensions, resulting in the enforced liquidation of those portfolios being put together busily today, the story could be very different.
For the quote of the week, I must return to Warren Buffett. The letter he sent to shareholders – distributed on the internet – included an immortal phrase that seems to owe more to Zen Buddhism than a disciplined and thoughtful investment process: "In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. Our appraisal of 1997's performance, then: quack."