IMA statistics highlight this fall from grace as the average fund has dropped 27.7 per cent in the past 12 months. They were down by 29.5 per cent over a three-year timeframe, with the best performer still falling by 7.6 per cent.
But the bounce, as you would expect, has given small caps a boost, with a three-month average return of 18.4 per cent across the 57 funds in the sector. Even the lowest-performing fund is now in positive territory with a return of 2.9 per cent, while the leading fund has returned 77.3 per cent in that period.
The cyclical and domestic nature of smaller companies tends to see them outperform in bull markets and fare badly in bear markets. The risky nature of the funds is characterised by the fact that firms tend to have high debt-to-equity ratios while the majority of funds also report high betas in relation to the market.
But where does that leave advisers in the midst of what some are calling the start of a bull run and others are saying is nothing more than a rally?
Hargreaves Lansdown head of research Mark Dampier believes deciding whether or not to invest in UK small caps is entirely down to how investors view the current rally, as they have largely benefited from the upturn.
He says: “I prefer the likes of Old Mutual and Standard Life’s UK small-cap funds as they have tended not to do terribly well in rallies like this as the managers focus on better companies than those cyclical ones.
“This is a banking recession. It is not the same as 2003 and there will still be problems with leverage which indicate investors should be cautious.”
Skandia UK best ideas is a good indicator of how leading UK fund managers perceive the small-cap arena. Just 0.1 per cent of the fund was invested in FTSE small cap and 2.2 per cent in FTSE Aim at March 31, suggesting the 10 leading managers maintain a bleak outlook.
Ignis UK smaller companies fund manager David Clark says the sector is still cheap despite some astonishing price moves.
He says: “We have been surprised by the extent and the pace of some of the moves, especially in sectors where we believe significant problems have yet to be fully realised. That said, we have been trading quite aggressively in order to reposition the portfolio.
“This is bearing fruit and although we are some way behind our median in the year-to-date, there is everything to play for.”
Jupiter UK smaller companies fund manager Richard Curling adds that low exposure to financials has helped small caps, as has the trend to move out of defensives into cyclicals.
He says: “A large amount of capital raised through rights issues dented cash balances of institutional investors. As a result, they may have sold defensive shares that had performed well to make funds available to participate in share sales.
“After reaching new multi-year lows early in March, equity markets rebounded towards the end of the first quarter. Nevertheless, the small-cap market still offers great opportunities to buy quality businesses on low valuations.”
Whitechurch Securities managing director Gavin Haynes says: “I have been surprised by how well they have rallied in the past six to eight weeks and there have been some exceptional valuations. The key thing is there are so many companies across so many sectors that there is an attraction over a one- to three-year view.
He notes they remain a geared play on the economic recovery and at this point there may be further uncertainty to come before investors can move into the area.
Haynes says : “There is an attraction and not just for the high-risk investor. I would tend to go for a special situations fund due to its flexibility but that may change in the next few months if the market continues to recover.”
Chelsea Financial Services managing director Darius McDermott says a UK small-cap rebound had to happen at some point, given how low valuations had become in companies that had been oversold regardless of how good their fundamentals were.
“I would now have some exposure to UK small caps as opposed to 12 months ago, but I would still go with a multi-cap portfolio.”