Is small still beautiful?

Small is supposed to be beautiful. Well, tell that to investors who held shares in the small companies listed on the UK stock market during the first half of 2022 – the more accurate word for their experience would be ugly.

Blue-chip shares didn’t exactly set the world on fire over the first half, with the FTSE 100 Index dropping by around 3%. But that was pretty good compared to smaller company performance: the FTSE 250 Index fell about 19% over the six months to the end of June, while the FTSE Small Cap Index was down 13% or so.

The explanation largely lies in investors’ appetite for risk. During periods of uncertainty and anxiety, investors’ demand for assets perceived as carrying more risk naturally tends to diminish. Russia’s invasion of Ukraine, particularly when allied with the ongoing disruptions of Covid-19 and a spike in inflation, certainly unnerved investors during the first half of 2022. And smaller companies, with less breadth and depth to cope with bad news, saw investors jump ship accordingly.

Smaller companies-focused investment companies, naturally, have not been immune to this sell-off. The average fund in the Association of Investment Companies’ UK Smaller Companies sector registered a loss of 28.7% over 12 months to the end of June. A widening in the discounts at which shares in these funds trade relative to the value of their underlying assets has added to the misery – the typical smaller companies fund now stands on a discount of 13.6%.

It would be understandable if these numbers had left investors questioning their holdings in smaller company funds and shares. No-one is happy with an investment that loses almost a third of its value in such a short space of time. But it is important to be circumspect here – there is good reason to keep the faith.

The truth is that smaller company share price performance is significantly more volatile. In any market cycle, smaller company returns tend to be at the extremes, for good or for bad. Investors’ anxiety during difficult periods often proves overdone – just as their confidence tends to run ahead of reality in happier times.

Some long-term data provides perspective. Over ten years to the end of June, the AIC’s statistics suggest, smaller company investment companies have still outperformed their counterparts with a large company focus. The former delivered a gain of 189% over that period, compared to 147% from the UK All Companies sector of the AIC’s universe.

Look at even longer-term figures and the story is even more positive. Research published 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. By contrast, £1 invested in UK large companies over that same 65-year period would have grown to only £1,054.

The investment guru Jim Slater once pronounced “elephants don’t gallop” when asked about the relative merits of investing in small and large companies. It’s an important point – small companies, by their very nature, have more potential to grow quickly and to deliver outsized returns. There may be ups and downs along the way, but the long-term potential is exciting.

Small can still be beautiful, in other words. But investors need to tread carefully when thinking about how to get their exposure. Small company shares can often be less liquid, which puts investors who need to get in and out of the market quickly in danger. That’s particularly the case for funds, whose size may prompt prices to move against them.

Open-ended funds are vulnerable to this issue, since they need to deploy capital as investors come into the fund, and pull back as they move out. Investment companies, by contrast, don’t suffer in this way – and may therefore be a better bet at this end of the market.