UK smaller companies was one of the best-selling sectors in the last bull market but has endured a difficult time in the past few years as market falls and liquidity concerns have taken their toll.
Looking at the IMA statistics for UK small caps 18 months ago, the average fund in the sector had fallen by 27.7 per cent in the previous 12 months.
However, the last 12 months tell a different story. The sector has an average fund return of 20.1 per cent, which make it one of the best sellers in the market. The top seller, Close special situations, returned 55.1 per cent.
Advisers are generally wary of taking bets in smaller companies due to the risks. The sector has both a cyclical and domestic nature, meaning falls in the markets can hit these funds hard, as was the case in 2008.
Hargreaves Lansdown investment manager Ben Yearsley says the company currently recommends five UK small-cap funds in its Wealth 150. He feels the key to investing with them is a long-term approach.
Yearsley says: “You need to go with experienced people who have a consistent approach. We try to steer clear of those managers who can shoot the lights out but might also suffer badly because of their cyclical nature.
“Liquidity is also a problem that cannot be overlooked for the market. I would suggest that an investor with a 50 per cent holding to UK equities should have 5 to 10 per cent of their portfolio in UK small caps at the moment, given the raft of leading managers such as Harry Nimmo and Giles Hargreave.”
Bestinvest senior investment adviser Adrian Lowcock says although smaller stocks have outperformed recently, he continues to recommend exposure to the sector.
He says: “Fund managers have historically been able to add value in the smaller-cap arena as markets are not as efficient and companies do not have as many analysts following them, so information is not as perfect.
“We continue to recommend investors have exposure to the sector and to strong managers.”
Investec UK smaller companies fund manager Philip Rodrigs believes there is continued upside to be made from UK smaller companies.
He says the recovery draws strong similarities to the one seen in 2003, with a huge rally that stopped briefly and then continued.
He says: “We have seen the market drive up strongly from August this year and I believe we are going to continue in an upward trend. Every single recession, there is talk of a double-dip and it is not often the case.”
Rodrigs says there is an abundance of undervalued companies in the market but that any cyclical addition to his portfolio has to be one that is taking market share.
He says: “That shows it is a better than average company with a better than average business model that allows it to take market share from its competitors.
“If the signs show that we are in a recovery, you get a boost from the cyclical aspect of that business model above the market share, meaning you get two sources of market gain. It is these companies that are undervalued compared with the market.”
Liontrust UK smaller companies fund manager Anthony Cross says there have been bouts of opportunities for small caps in the past three years and he believes the trend will continue.
He says: “The small caps that have tended to do well are the larger ones but there are a number at the lower end being left behind.”
Cross says liquidity is a concern but does not feel that is why investors have steered clear of the market.
He says: “It is all down to asset allocation. Small caps are a tiny part of the All Share and they get neglected, despite the opportunities to make big money.
“Next year will be volatile for small caps as the market focuses on macro-economic issues. The key for managers is to ignore that and focus on individual companies.”