by Dewi John.
There’s a lot of talk about small caps being a good play for 2021. A look through historical data shows that’s a bit like the kid who raves about the new, happening band when all their with-it peers have known about it for ages. Although I’m sure no-one who is even slightly with-it uses ‘with-it’ anymore.
In other words, small-cap outperformance isn’t so recent. I looked at the large versus small cap equity funds returns last year and found that small caps outperformed large caps in eight out of 13 regions. Developed market small caps outperformed (apart from in the US), whereas in emerging markets and the US, large caps came out on top—albeit in the US by just a whisker. If you strip out the handful of large-cap tech leviathans, then the US looks like other developed markets.
The average Equity UK fund lost 7.3% in 2020 while its small cap equivalent delivered 4.4%, so the performance differential is significant. UK Smaller Company returns for the 12 months to the end of April were a more satisfactory 12.2%. This period excludes the market declines over the early part of the year as the pandemic crisis started to bite—although it still captures the plummet in March. The three-year average return is 23.6%, with only one fund in negative territory. When compared to UK large caps, over one and three years, the sector has treated its investors well.
Will this continue? Small caps tend to perform well in recoveries. However, as illustrated, this outperformance is no new thing, so the question is, how much further does the small cap run have to go? If the recovery does persist over the coming months—and that’s the overwhelming consensus—then the case for small caps remains strong.
That said, small caps do tend to be more volatile than their large cap peers. This is indicated by the relatively low Lipper Leader preservation scores, which are calculated from a universe of more than 17,000 funds. No funds in the sector score a maximum of 5, and only two in the top 10 for three-year returns have a 4. What’s more, as you go down the list, the 1s become ever-more frequent. But if you’re happy to ride out the volatility, selecting a good smaller companies fund could set you up with some decent returns over time.
As you can see from the table, the top fund over three years, FP Octopus UK Micro Cap Growth, delivered more than 70%. It scores a 5 in the Lipper Leaders Consistent Return, indicating that the fund has a strong tendency to outperform its peers in both rising and falling markets, producing good risk-adjusted returns over the five-year period of the calculation. Indeed, within the table, seven funds have such a rating and two are rated a 4, indicating a relationship between good risk management and consistent return.
But it’s important to note for anyone considering small caps that while good managers will constrain risk, heightened levels of it are inherent to the sector.
Table 1: Top-Performing UK Smaller Companies Funds Over Three Years (with a minimum five-year history)
Source: Refinitiv Lipper. All data as of February 28, 2021; Calculations in GBP
This article is reproduced from the April edition of Moneyfacts magazine, on page 24 here.
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