Smaller company trusts profit from mid-caps

Recent analysis by broker Numis Securities finds that at least six Association of Investment Companies (AIC) UK Smaller Companies sector investment trusts have 50 per cent or more of their assets in FTSE 250 shares. Though they are not doing anything outside their remit, Adam Steiner, chief executive officer of SVG Investment Managers which runs Strategic Equity Capital (SEC) investment trust, argues that it is misleading for investors to categorise what are effectively mid-caps trusts in a sector called smaller companies.

AIC UK Smaller Companies trust asset allocation

Source: Numis Securities, AIC, trust providers

However, Annabel Brodie-Smith, director of communications at the AIC, says: "It is important to remember that this is the UK Smaller - not small companies sector. Our sector definition is: 'Companies (investment trusts) which invest at least 80 per cent of their assets in UK smaller companies securities.' And you can widely define what a UK smaller company is."

For example, you could refer to a mid-cap share as a smaller company because it is smaller than companies in the FTSE 100. Most UK Smaller Companies Trusts use the Numis Smaller Companies Index rather than the FTSE Small-Cap Index. The Numis index represents the bottom 10 per cent of the UK market, and at the start of 2013 it had 362 constituents (excluding investment companies) with an average market cap of £267m. However, FTSE 250 shares account for 78 per cent of this index, according to Numis.

"Smaller companies as defined by the bottom 10 per cent of the market are what people typically think of as smaller companies internationally, and this is a widely accepted definition of smaller," says Neil Hermon, manager of Henderson Smaller Companies investment trust (HSL), which has 81 per cent of its assets in mid-caps (and recently won Best UK Equity Growth Fund in the Investors Chronicle Fund Awards). "The FTSE Small-Cap Index is very narrow and you couldn’t construct a portfolio out of that."

The FTSE Small-Cap Index ex investment companies only accounts for 1.1 per cent of the UK market, down from 6.5 per cent 15 years ago.

Mr Hermon also argues that his trust is not misleading. "Our benchmark has been the Numis Smaller Companies Index (excluding investment companies) for the last 10 years and our portfolio allocation to mid-caps is very similar to this index. We are very upfront about what we do and invest in, and clear about that in our marketing literature. A large portion of our assets is in mid-caps because that is where we see value and opportunities. Many of our mid-cap holdings were also bought when they were FTSE Small-Cap shares - we have a long-term investment horizon and tend to run the winners - we think that it is all right for companies to grow and get bigger."

Read more from Neil Hermon on why mid-caps are the place to be.

Funds holding assets that their sector name doesn't suggest is not unique to UK Smaller Companies Investment Trusts: global growth investment trusts, for example, may have an allocation to the UK, while some unit trusts and open-ended investment companies in the Investment Management Association (IMA) UK Smaller Companies sector also have exposure to mid-caps.

There is also no AIC UK mid-cap investment trust sector to separate out mid-cap from small-cap focused investment trusts.

"You can never have a totally uniform sector," says Ms Brodie-Smith. "Portfolio allocation does vary - this is part of active management and it would not be right to restrict this as investors could lose out from a lack of investment flexibility."

And if the investment trust you are invested in is doing well, should you really care whether the majority of holdings are FTSE Small-Cap or FTSE 250 - especially as some of the trusts heavily allocated to the FTSE 250 have made strong returns?

Problems

Most smaller companies investment trusts use Numis Smaller Companies ex UK index as their benchmark and measure for performance fees. However, Dunedin Smaller Companies Investment Trust (DNDL), managed by Aberdeen, uses the FTSE Small Cap ex Investment Companies index as its benchmark and performance fee measure, despite the fact that about 62 per cent of its assets are invested in mid-caps. Some argue that this is unfair because in recent years the FTSE 250 has done better than the FTSE Small-Cap, in effect making it easier for this trust to beat its benchmark and trigger a performance fee.

However, Aberdeen disagrees saying part of the reason for the high allocation to the FTSE 250 is because this trust is not compelled to sell a holding if it is promoted into the FTSE 250. "Given the strong performance of the portfolio in recent years and longer, a proportion of the portfolio currently now falls within the FTSE 250 range, £316m to £3.6bn," says a spokesperson. "Dunedin's largest holding by market cap is Weir Group (WEIR) in the FTSE 100 with a market cap of about £4.5bn, which has been held since it was a small cap. Similarly Intermediate Capital (£1.7bn) (ICP), Bellway (£1.6bn) (BWY), Aveva (£1.5bn) (AVV) and Victrex (£1.4bn) (VCT) have also been held for years.

The trust's manager, Ed Beal, occasionally initiates an investment in a company on the border of the FTSE 250 and FTSE Smaller Companies indices, but he's certainly not initiating investments in companies towards the top end of the FTSE 250. Overall given Dunedin's focus towards the lower end of the UK market the current benchmark seems the most appropriate. It is reviewed by the board regularly who consult with shareholders during visits. The performance fee, meanwhile, is capped. Aberdeen receives 10 basis points per 1 per cent of outperformance up to 5 per cent, so the maximum performance fee in any given year would be 50 basis points."

Dunedin Smaller Companies share price has also beaten the FTSE 250 over one, three and five years.

Until recently, Montanaro UK Smaller Companies Trust (MTU) had also used the FTSE Small Cap ex investment trust index as its benchmark and performance fee trigger, but since 1 April this year the benchmark has changed to Numis Smaller Companies Index ex investment trusts. This trust also has only 35 per cent of its assets in FTSE 250 shares.

Small companies investing in mid-caps could also be a problem if you already have exposure to mid-caps and bought smaller companies funds in the belief that you were diversifying, but in reality have more exposure than you want your portfolio to have to the FTSE 250. Mr Steiner also argues that if you are paying a fund you think is allocating to one area of the market it is disappointing if you find that it is allocating you elsewhere. "It is against the interests of investors who genuinely want smaller companies to get growth, because the smaller the companies, the better returns you are likely to get."

While investment trust and fund fact sheets routinely provide a breakdown of the sector allocation, and where appropriate the geographic allocation, it is not usual to find their market-cap allocation. However, you can get information on a UK focused investment trust's market cap breakdown on the AIC website at http://www.theaic.co.uk/aic/statistics/aic-stats

A good way to gauge a fund's performance can be to see how it is doing against its sector, and as most UK Smaller Companies investment trusts have a high proportion of mid-caps you can compare them against each other. In the case of those for which this is not the case it is important to compare them against an appropriate index, so as with any fund before investing do your research and know and understand what its assets are.

If you want to get exposure to very small companies, Simon Moore, senior research analyst at wealth adviser Bestinvest, suggests you look at some of the specialist unit trusts and open-ended investment companies focused on this area, particularly those run by small asset management companies. This is because large asset managers with many funds don't invest in very small companies as their aggregate exposure to the company would be very large.

Open-ended funds focused on this area include IC Top 100 Fund Marlborough UK Micro Cap Growth (GB00B02TPH60) and Cavendish AIM Fund (GB00B0JX3X39).

Read our interview with Cavendish AIM Fund's manager

Read more on funds to access Aim

You can screen funds for the size of their underlying holdings at www.morningstar.co.uk, however, size does not necessarily translate into performance so you may be better choosing a fund because of its performance and strength of its investment team.

AIC UK Smaller Companies trusts performance

Source: Morningstar

Performance data as at 19 April 2013