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Reading the small print

As investor risk appetite has started to return, so too has interest in “riskier” investments such as emerging equity markets and smaller companies.

These investments can fulfil a valuable role in a portfolio by helping to generate returns.

However, the level of volatility can be high – as we all saw last year – and investors need to consider what their requirements are and their tolerance for risk before adding them to a portfolio.

In the year to, smaller companies have provided some of the strongest returns and, for many investors, taking a degree of exposure to UK smaller companies is the right decision at this point in the cycle.

We would go a step further however, and suggest that investors should not overlook the potential attractions of European smaller companies too, before making a decision.

The characteristics of the UK smaller companies and European smaller companies markets are similar: strong return potential, higher than average levels of volatility and exposure to niche businesses that can be difficult to access through bigger companies.

One of the major differences, however, is in size. The European smaller companies market is more than 10 times the size of the UK market, offering rich pickings for managers who are able to select stocks that outperform.

For UK investors, the other main difference is currency exposure, which can enhance or erode sterling returns investors depending on how currencies perform.

This is undoubtedly an additional risk factor investors must consider, and exposure to European smaller companies may not be for everyone.

However, it should not be forgotten that they do fulfil fundamentally the same role in an investment portfolio as UK smaller companies, and it could be a costly mistake to overlook them when constructing a portfolio designed to deliver long-term capital growth.

Over the last six months, European smaller companies have delivered a significantly stronger return than UK smaller companies and, over the long term, European smaller companies exhibit less risk too, as measured by standard deviation.

The key question, of course, is what to look for when selecting a smaller company manager, whether for UK or European smaller companies. The very nature of these “high-risk” investments means that there is a large dispersion of manager returns, so selecting the right manager really does matter for these asset classes.

Analysing risk as well as return is the key. Looking at the investment returns generated over different periods of the economic cycle is important – and how that compares with the peer group – but so too is the level of risk taken to generate these returns, as that affects the volatility of returns.

Understanding the investment process followed by the manager is also crucial.

Different managers can have success with different investment approaches, but the key thing here is to understand what the investment process being followed by the manager is and whether any success the manager has had with this process is likely to be repeatable.

The experience of the investment manager is another valuable factor to look at. Up and coming managers can deliver good returns but may lack the experience to be able to adapt their strategy as market conditions change.

Whether you select UK or European smaller companies, one thing is clear – in an environment where risk appetite is increasing again, size matters.

Ian Pascal is marketing director at Baring Asset Management

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