Miniature heroes

David Prosser on why smaller companies look set to outperform.

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Smaller companies funds have been the stand-out performers as the UK stock market has moved higher during the first few months of the year. That reflects the dramatic outperformance of smaller companies: while the FTSE 100 index of blue-chip stocks has risen by around 6% since the beginning of the year, the FTSE Small Cap index is up by almost 16%.

The gains come amid growing confidence in the ability of the UK economy to grow strongly in 2021, given the excellent progress made on the roll-out of Covid-19 vaccines. Barclays Bank has just predicted that the country is in for the biggest economic boom since 1948 this year. Smaller companies tend to be better when the expectation is that the domestic economy is well-placed to expand, since they tend to be more UK-focused with less exposure to international economies.

It will not surprise you to hear that investment companies have been the most profitable way to win in smaller companies so far this year. The average UK smaller companies investment company was up 9.4% over the first quarter of 2021 – ahead of the 9.0% achieved by its typical open-ended fund counterpart.

There are good reasons for investment companies to outperform in rising markets, including their unique ability to take on gearing, which boosts returns. And when it comes to smaller companies, which can sometimes be illiquid, particularly at the smallest end of the scale, investment companies have additional advantages given their structure. They are a better fit for exposure to asset classes where liquidity can be an issue.

Moreover, via investment companies, you do not have to stick to listed smaller companies. Listed private equity funds and venture capital trusts both give retail investors an opportunity to get into unlisted businesses that have yet to make it on to the stock market.

These businesses have a great deal to offer. They have a similar profile to listed smaller companies in the sense that they also tend to outperform when the UK economy is doing well. But they are at an earlier stage of their growth trajectory; this is often the stage at which growth is most explosive. By the time these businesses seek a stock market listing, the period of their most rapid expansion may be behind them.

Private equity funds provide a way for retail investors into an asset class that has traditionally been the preserve of institutional investors able to make large investments and tie up their cash for an extended period. The liquidity of an investment company’s listing on the stock market enables investors to get in and out of these funds as they wish, even though the underlying holdings are much more illiquid.

Venture capital trusts are a little different, with strict rules governing the size and activities of the businesses in which they are allowed to invest. This reflects the fact that generous tax reliefs are available to investors in these funds, designed to encourage the flow of funding into the smallest companies.

The risk profile of unlisted businesses does tend to be higher than those companies listed on the stock market. Not only are they smaller, but there is also less publicly available information on them. Still, investing through an investment company, with a diversified portfolio of holdings, provides some protection.

None of which is to suggest that these funds are right for everyone. Still, if smaller companies do continue outperforming this year, investment companies will be a good option for capturing those returns, from both listed and unlisted companies.