Why UK smaller company funds are under the cosh

This part of the market is out of favour. Kyle Caldwell explains why investors' patience may be rewarded over the long run.  

Investors are continuing to ditch equity funds, with data from global funds network Calastone showing that £310 million was withdrawn in May.

Calastone, which tracks flows in and out of investment funds from financial advisers, platforms and institutions, says that it is the worst start to the year for equity fund flows since it began its analysis eight years ago. Calastone says it captures more than two-thirds of fund flows by value every month.

In its latest analysis, Calastone says that UK funds continue to be out of favour, with £836 million pulled last month.

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In particular, the firm notes that UK smaller company funds “took particular punishment”. The sector accounted for £1 in every £6 of the May outflow, double their share of UK-equity assets under management.

Sentiment towards the UK market remains poor, despite the FTSE 100’s outperformance of US markets so far this year. Year-to-date, the FTSE 100 has lost 1.8% versus respective declines of 18.1%, 13.6% and 27.5% for the S&P 500, Dow Jones and Nasdaq.

The FTSE 100’s strong relative performance is a consequence of a bias to ‘old economy’ stocks that make most of their money overseas, including oil companies, miners and banks.

In contrast, UK mid- and small-cap indices, which house stocks that tend to generate most of their profits in the UK, have fared badly. The FTSE 250 is down 19.4%, while the FTSE SmallCap index has given up 12.8%.

The same pattern plays out in terms of fund performance. Data from FE Fundinfo shows the UK Smaller Companies sector is down 18% year-to-date. This compares to a loss of 8.6% for UK All Companies, and a small loss of 1.6% for UK Equity Income.

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George Ensor, fund manager of  River and Mercantile UK Micro Cap (LSE:RMMC), points out that it is par for the course when investing in small-sized shares to have “these periods of high stress”.

Ensor adds: “Investor sentiment is low. There are concerns about where we are in the cycle, and the risk of possible recession. Given this backdrop, there’s a lack of risk appetite to own smaller companies.”

He notes that such times present opportunities for him to pick up bargains that will hopefully pay off on a three- to five-year view.

Ensor has been putting cash to work, adding to ActiveOps (LSE:AOM), a provider of workplace management software, and Renold (LSE:RNO), a chain designer and manufacturer.

He said: “Cash levels are now at the lowest they have been since I took over management of the trust in 2018. Stocks across the board have fallen aggressively, but this provides opportunities.”

Piping-hot inflation cooling down was cited by Ensor as a potential catalyst to improve investor sentiment, and in turn results in money returning to UK funds. 

For Paul Marriage, who manages TM Tellworth UK Smaller Companies, the turning point will be when investors get past “peak grumpiness”. He notes that while there could be further short-term pain, a lot of bad news has been priced into valuations. 

In a recent video interview, as part of our Insider Interview series, Marriage added that it is not a surprise that smaller companies have been out of favour. He said: “When markets are scared about things like a war in Europe or macroeconomic issues, UK small-cap is the sort of asset you run away from, really. It's not something you buy on first missile, unfortunately, and it's not something you really buy when you're worried about the domestic economy.”

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Marriage points out while there’s more risk involved compared to buying a blue-chip company in the FTSE 100, the potential rewards are bigger. However, he stressed that investors need to be committed to investing for the long term.

“The way I sometimes think about it is, we're buying companies that can kind of walk, talk and feed themselves. You know, they're like toddlers. So they're age three. And we're owning them from sort of three to teenagers, to 14. So that share price might be going from £3 to £14.

“They [then] become annoying, grumpy teenagers at 14 and [we] get rid of them. So that is a period of maximum growth.

“Now from 14 to 28, the next doubling might take three or four years, whereas we’ve got a four or five times share price appreciation.

“So that's how, over 10 years, you generally get these long-term outperformances.”

Investing in small companies

A powerful long-term investment trend is smaller shares’ outperformance of larger companies.

There is plenty of logic behind the argument. Smaller companies have higher potential for growth. As the late Jim Slater said, “Elephants don’t gallop.”

This part of the market is also less intensively researched by analysts, giving investors and fund managers who do invest in smaller companies greater chance to gain an edge.

The numbers speak for themselves: research by the London Business School found that £1 invested in 1955 in UK smaller companies would have grown to £7,933 by the end of 2020. In contrast, £1 invested in UK large companies over that 65-year period would have grown to £1,054.