The best way to profit from smaller companies

Richard Staveley, manager of the Rockwood Strategic Trust, a smaller companies specialist, says the data underlines the attractions of investment trusts for smaller companies exposure. In comments made to Trustnet recently, he described them as a “much more appropriate structure” for holding these assets.

The main issue here is liquidity. There isn’t a huge market for shares in many smaller companies, so it can be difficult to buy and sell such stocks quickly, particularly for anyone dealing in larger volumes. That worries investors who might need to trade in a hurry – like the manager of an open-ended fund – who must work around the unpredictable ebbs and flows of investments in and out of the fund.

To guard against a situation where they find themselves forced to sell at bargain-basement prices to meet redemption demands from their investors, open-ended fund managers must either steer clear of more illiquid smaller companies or hold more of the fund in cash as a buffer to make payments from. Either way, that can prove to be a drag on returns.

Investment trusts have no such problems. The structure of an investment trust – a closed-ended fund that investors buy or sell on the stock market – means managers don’t have to worry about this issue. They’re free to invest in even the most illiquid of smaller companies if they think there are decent returns to be made from doing so.

That freedom can make a huge difference, as the data shows. Fund managers always prefer to have an unfettered choice of options in their chosen asset class – but when it comes to smaller companies, it’s often the most illiquid stocks that offer the greatest long-term allure. These may be the smallest businesses that few investors have yet discovered, or larger companies that are out of favour. Either way, fund managers unable to invest for fear of a liquidity problem are at a significant disadvantage.

In practice, the typical smaller company held by an open-ended fund will be a larger business than at a comparable investment trust. That’s particularly true for the biggest open-ended funds, which make larger investments and therefore worry about liquidity issues to a greater extent. Investment trusts can also gear, which can enhance long-term returns, though it adds risk too of course.

This debate isn’t completely one-sided. The investment trust structure does pose some challenges that investors will need to consider. Shares in investment trusts themselves can sometimes be illiquid – not necessarily an issue for retail investors but potentially problematic for larger buyers. And investment trust shares will sometimes trade at a discount to the value of the underlying portfolio, as demand and supply get out of sync with asset prices. That can hold performance back.

Nevertheless, the data suggests investment trusts have, in the past at least, offered a superior route into smaller companies. There can be no guarantees this will continue, but if you’re looking for exposure to this area of the market, considering a fund that has greater freedom in stock selection feels like a sensible idea.