Go global for smaller companies

If you're after high growth, smaller companies are the area of the equity market to turn to. The risks may be higher but the evidence is undisputed that over the long term smaller companies have outperformed larger companies.

One of the most compelling arguments for small-cap investing is that these companies can grow more strongly than large-caps which may already have reached their peak.

Many UK smaller companies funds and investment trusts have delivered strong returns over the years. Examples include IC Top 100 Funds Henderson Smaller Companies Investment Trust (HSL), BlackRock Smaller Companies Trust (BRSC) and Marlborough UK Micro-Cap Growth Fund (GB00B8F8YX59).

However, investors have a tendency to look first to their home markets and in some cases get overexposure, while if you invest in UK shares as well as UK funds there is a risk that you will duplicate some of your holdings.

You should also look overseas to the growing number of global and regional smaller companies funds available, some of which have made strong returns. An overseas smaller company fund will diversify your portfolio and give you exposure to a wider range of growth opportunities.

Long-term strategy

Because of their risks you should not invest in overseas smaller companies funds unless you have a long-term time horizon of at least five years, a high-risk appetite and are prepared to accept losses.

Overseas smaller companies funds should only account for a small proportion of your portfolio: advisers recommend that they do not account for more than around 5 to 10 per cent. Some more general funds may include exposure to small-caps, for example recovery and special situations funds, so consider whether you will have any overlap before you invest.

With smaller companies it is a good idea to ensure the fund is not too large, or it can't take meaningful positions in small companies.

Smaller companies are less easy to buy and sell, and can take a long time to realise their potential, so an investment trust could be a better option for investing in this area. Investment trusts can hold their investments for the long term because they do not have to sell them to meet redemptions when investors withdraw their money. But there are some open-ended smaller companies funds that have made strong returns.

You can invest in global smaller companies funds or regional funds focusing on one area such as Europe, US, Japan or Asia.

You could use a combination of both as some sectors don't have good smaller companies funds. But if you have a smaller portfolio, a global smaller companies fund could be better as you can get wide diversification with one fund. Or if you don't have the time to do the research on which regions to invest in outsourcing this decision to a global fund with a good track record might be a good solution.

Regional funds are also theoretically higher risk than global funds because they are concentrated on one area.

Best overseas small-cap funds

We count F&C Global Smaller Companies (FCS) investment trust among our IC Top 100 Funds. This has a good performance record beating the AIC Global sector average over one, three and five years.

The trust is on a slight premium to net asset value (NAV) which is a typical level for it.

It has a very reasonable ongoing charge plus performance fee of 0.76 per cent.

This invests both in other funds and directly in shares.

Its largest exposure is the US, accounting for 40 per cent of assets, followed by the UK at 30 per cent. The large UK exposure means it does not provide as much geographic diversity as some other global funds. However the geographic allocation is not static, so could change depending on where its manager, Peter Ewins, thinks are the best opportunities. And you could also use it as a one-stop shop for your UK and overseas global smaller companies allocation.

Open-ended options - funds not listed on the stock market - include Baillie Gifford Global Discovery (GB0006059330). This is the top performer among all Investment Association (IA) Global funds over three years, and is among the top few over one. The fund invests in companies that offer significant growth prospects with an emphasis on ones operating in industries with potential for structural change and innovation. Its largest sector exposures are IT and healthcare, accounting for 31 and 30 per cent of assets respectively.

The fund can be bought from platforms for an ongoing charge of about 0.78 per cent.

A downside is its short track record - the fund was only launched in 2011 - so it remains to be seen how it performs over the long term - the time period over which you should invest in smaller companies.

Morningstar, as at 9 October 2015

Regional funds

If you are going to go for regional funds, some advisers and analysts are keen on Europe and Japan. "We are cautious on US equities and Asia ex Japan, but upbeat on Europe and Japan, two regions where monetary policy remains very accommodative and supportive of domestic equities," says Jason Hollands, managing director at Tilney Bestinvest.

"While the eurozone's economic recovery continues to gain ground, global volatility has hit European equities, leaving them looking reasonably valued, although not cheap on traditional metrics," adds Stephanie Flanders, chief market strategist for Europe at JPMorgan Asset Management. "Continued growth in corporate earnings and profitability, along with highly supportive monetary policy provides upside potential for asset prices, particularly in domestically oriented sectors that can now benefit from the recovery."

Smaller companies tend to be more exposed to domestic economies so could be a good way to play this recovery.

IC Top 100 Fund European Assets Trust (EAT) invests in small- to mid-size companies across Europe that offer the potential for strong growth.

The trust has done well in this respect, beating Euromoney Smaller European Companies Index by a good margin over one, three and five years. It also beats all its Association of Investment Companies (AIC) European Smaller Companies sector peers over three and five years.

Another of European Assets' aims is to provide an attractive income, and at the moment it offers a very attractive yield of more than 5 per cent. But the trust is on a premium to net asset value of 2 per cent above its 12-month average of 0.46 per cent.

JPM European Smaller Companies Trust (JESC) is on a discount to NAV of more than 10 per cent, albeit tighter than its 12-month average of 11.5 per cent, and it has traded at even wider levels. This trust has also beaten the Euromoney Smaller European Companies Index by a good margin over one, three and five years, and beat European Assets over one. If its good performance continues, the discount could tighten further.

It has an ongoing charge of 1.32 per cent, while European Assets charges 1.34 per cent.

Morningstar, as at 9 October 2015

Japanese companies have benefited from a currency-fuelled improvement in their global competitiveness. "A weak yen should continue to be a feature of the financial landscape given the Bank of Japan's ultra-loose monetary policy," says Luca Paolini, chief strategist at Pictet Asset Management. "Due to improvements in corporate governance, companies are making more efficient use of their balance sheets, which holds out the prospect for a steady increase in the market's return on equity. Corporate profit margins are also on the rise."

For exposure to Japanese smaller companies, IC Top 100 Fund Baillie Gifford Shin Nippon (BGS) investment trust has massively outperformed MSCI Japan Small Cap Index over one, three and five years, and all of its sector peers.

It has an ongoing charge of 1.17 per cent.

But the trust is on a premium to NAV of 1.9 per cent above its 12-month average - a discount of 1.9 per cent.

If you would rather not buy it while on a premium Baillie Gifford Shin Nippon's manager, John MacDougall, also runs Baillie Gifford Japanese Smaller Companies Fund (GB0006014921). This too has a strong performance record and is the top performing IA Japanese smaller companies open-ended fund over one, three and five years.

It also has a much lower ongoing charge of 0.63 per cent.

Mr Hollands suggests Legg Mason IF Japan Equity Fund (GB00B8JYLC77). "For investors prepared to take a much higher-risk approach to Japanese small-cap investment, Legg Mason IF Japan Equity focuses on fast-growth companies and is predominantly invested in small- and mid-cap stocks," he says.

This fund has made very strong returns and is the top performing IA Japan sector fund over one and five years, and second over three years out of more than 50 funds.

You can buy Legg Mason IF Japan Equity Fund on platforms for an ongoing charge of about 1.08 per cent, and it also offers a hedged share class (GB00B99C0657), with a slightly higher charge of 1.18 per cent. Currency hedged share classes can combat the hit you take from converting returns from a weak foreign currency back to sterling.

However, at the moment the unhedged share class is probably the better option, according to Mr Hollands. "I'd probably go for the unhedged version as Yen depreciation has played out so heavily, while fears about China and an emerging market crisis are putting upward pressure on the Yen as the region's reserve currency," he says.

Morningstar, as at 9 October 2015