Small is beautiful

Small really can be beautiful. But while there are plenty of modestly-sized investment companies delivering market-beating returns, these funds are often on more lowly ratings, analysis published in the latest edition of Investment Week reveals. Using AIC data, it points out that shares in 41% of investment companies with a market capitalisation of more than £250m are trading at a premium to the value of the funds’ underlying assets. By contrast, the figure is only 18% amongst funds below the £250m threshold.

The divide reflects the reality that larger financial advisers, wealth managers and platforms are reluctant to invest in smaller investment companies. They worry that because they trade on behalf of large volumes of clients, their dealings in these funds will move the market to their disadvantage. The effect is then compounded by the fact that many investors follow the lead of these firms, so retail interest in smaller funds may also be more limited.

Let’s park the argument about whether liquidity fears really do justify giving smaller funds a miss if you run a large wealth manager or adviser. The truth is that this is what happens. In which case, the next question becomes, should everyone else steer clear of these funds, if they’re doomed to remain on depressed valuations because of lack of appetite from larger investors?

The short answer is no. For one thing, let’s remind ourselves what a discount really means: you are being offered an opportunity to buy assets at a price below their current market value. The chance to get in on the cheap is always worth at least considering for investors – particularly those who able to take a long-term view, since you can then afford to be patient in waiting for the correction.

Also, smaller investment companies have certain advantages. For example, they can be more nimble. That may be particularly important for funds investing in certain types of asset – the smallest companies, say. Larger funds, by contrast, can sometimes be unwieldy – and struggle with liquidity challenges themselves as they survey the market.

Another consideration is that the top-performing small funds don’t tend to stay small for too long. Investment companies have the option of secondary issuance, swelling their size, and such initiatives will be well-supported if the fund has a track record of outperformance. There is also the potential for smaller funds to combine in order to achieve scale – there have been a series of investment company mergers over the past couple of years.

For all these reasons, an investment company with a manager who consistently delivers outsized returns is worthy of consideration for your portfolio whatever its size. Even if the fund’s market rating does not improve, you will still benefit from the rise in the value of its assets. And eventually, other investors will take notice, offering the potential for a double performance whammy as discounts narrow.

The alternative, of course, is to buy a larger fund trading on a premium. Here, you are being asked to do something very different – to pay more for an asset than it is currently worth. There may be good reasons to do so, but you will need to be confident that the premium can be sustained and that the manager can continue to deliver portfolio growth.

The principle here should be that if you don’t need to worry about liquidity when choosing an investment company, you shouldn’t spend too much time thinking about whether other people are doing so. A small investment company trading on a discount represents a potential bargain – so if you’re confident the fund can deliver, don’t be put off by its size.