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Small is beautiful over the long term

Smaller companies can deliver strong growth and aid diversification
February 28, 2019

Including smaller company equities in your portfolio can result in better returns over the long term and diversification. Developed market smaller company stocks, in particular, can be more closely correlated with the economy of the country where they are listed, whereas large-cap stocks are typically more aligned with the global economy. This is the case with the FTSE 100 index, which is composed of the UK’s largest companies. These derive around 66 per cent of their revenues from outside the UK, while smaller UK companies tend to derive most of their revenues from the UK.

 

The size of a company can help determine whether it has a chance of beating the market average. Other factors, known as 'risk premia', include value (buying underpriced stocks) and momentum (buying the stocks that have recently risen the most). Table 1 shows how these various factors have performed over the past 20 years, and being small has delivered returns significantly ahead of other risk premia.

 

Table 1: Factor outperformance

Index20-year cumulative total return (%)
MSCI World Small Cap649.97
MSCI World Momentum423.26
MSCI World Minimum Volatility 353.23
MSCI World Quality319.93
MSCI World Growth251.14
MSCI World Value227.11
MSCI World 222.64

Source: FE Analytics, as at 22/02/2019

 

Table 2 shows how small-caps have fared versus the general market and large-caps over different time periods in different regions. Small-caps have beaten large-caps over the long term except in Asia ex Japan, although in the short term this is generally not the case. So excluding smaller companies from your portfolio is likely to hamper long-term returns. The differentials can be quite large depending on the region: for example, over the 10 years to 20 February 2019, UK smaller companies outperformed UK large-caps by 203 percentage points. In Europe ex UK smaller companies outperformed large-caps by 162 percentage points and globally by 100 percentage points.

 

Table 2: Small-caps vs large-caps

RegionIndex1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)10-year return difference vs small cap (%pt)
Global equitiesMSCI World7.1156.8176.79262.96-93.85
MSCI World Large Cap7.8657.578.14256.65-100.16
MSCI World Small Cap5.3963.4574.03356.81-
       
US equitiesMSCI United Kingdom 3.9136.3727.01167.69-191.02
MSCI United Kingdom Large Cap5.4240.5528.11155.81-202.9
MSCI United Kingdom Small Cap-2.8230.9133.76358.71-
       
UK equitiesMSCI USA11.4966.19106.18359.59-81.17
MSCI USA Large Cap11.866.46109.44350.75-90.01
MSCI USA Small Cap13.4176.7689.26440.76-
       
Japanese equitiesMSCI Japan-2.3545.1668.88138.69-62.86
MSCI Japan Large Cap1.7547.0367.83134.39-67.16
MSCI Japan Small Cap-5.1251.8294.11201.55-
       
European equitiesMSCI Europe ex UK -2.3939.936.08167.22-153.1
MSCI Europe ex UK Large Cap-1.7938.132.73158.81-161.51
MSCI Europe ex UK Small Cap-8.7247.2757.28320.32-
       
Emerging market equitiesMSCI Emerging Markets -3.5465.7958.39190.4-37.81
MSCI Emerging Markets Large Cap-3.8168.2460.38189.98-38.23
MSCI Emerging Markets Small Cap-7.8441.2242.32228.21-
       
Asian equitiesMSCI Asia ex Japan-1.6465.3375.82251.5818.68
MSCI Asia ex Japan Large Cap-2.1367.2578.17252.6919.79
MSCI Asia ex Japan Small Cap-7.835.1140.22232.9-

Source: FE Analytics, as at 20/02/2019, GREEN is best performing

 

Smaller companies generally have better longer-term growth potential than larger companies. But it is not a smooth upward trajectory. Smaller companies didn't outperform larger companies over one, three and five years in many regions, and they didn't outperform larger companies across all time periods in any regions. In times of market stress smaller companies can underperform - as has happened recently. Chart 2 shows sales of Investment Association European, Japanese, North American and UK Smaller Companies sector funds in 2018 - generally a risk-off market. As the year progressed and volatility became more embedded, sales of smaller companies funds slumped. Flights to safety usually start in the riskiest areas, which means investors tend to divest of smaller company stocks first.

And these concerns are not unwarranted. Small-cap stocks come with huge risks. They are more likely to fail, resulting in significant capital loss. When markets are falling and investors are less tolerant of risk, falls are likely to be steeper among riskier and smaller companies. These types of stocks are also less easy to buy and sell, meaning that when investors want to exit them in times of stress they’re less likely to get a reasonable price for them. So when deciding whether to include smaller companies in your portfolio you need to consider whether their risk is worth the reward.

 

Impact on a portfolio

First of all you need to look at how an allocation to smaller companies affects an overall portfolio to determine whether their additional risk is worth potential extra growth.

Charles Younes, research manager at data company FE, says including smaller companies in a portfolio adds diversification and growth. “The drivers of small-cap equity markets are very different from those of large-cap markets," he says. "They are less sensitive to macro noises and industry calls, and more focused on growth and company-focused news. Smaller companies should improve the expected return of a portfolio.”

Table 3 shows the impact on risk and return of adding small-caps to a global equity portfolio. Portfolio 1 is a basic global equity portfolio. Portfolio 2 has the same geographical split as Portfolio 1, but with 25 per cent of each regional allocation and the overall portfolio in smaller companies. Portfolio 1’s holdings have an average market cap of nearly £4bn while Portfolio 2’s have an average market cap of £1.5bn. The average smaller company in Portfolio 2 is valued at just £59m, so its holdings have a lot of room for growth.

 

Table 3: Global equity portfolios

PortfolioIndex Allocation (%)1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)15-year cumulative total return (%)15-year volatility (%)15-year maximum drawdown (%)15-year maximum loss (%)
Portfolio 1MSCI United Kingdom404.4450.7657.98221.77241.2215.3940.8525.79
MSCI USA35
MSCI Europe ex UK10
MSCI Japan10
MSCI Emerging Markets5
Portfolio 2MSCI United Kingdom303.2250.3657.73263.39276.9415.3742.325.84
MSCI United Kingdom Small Cap10
MSCI USA 26.25
MSCI USA Small Cap8.75
MSCI Europe ex UK7.5
MSCI Europe ex UK Small Cap2.5
MSCI Japan7.5
MSCI Japan Small Cap2.5
MSCI Emerging Markets3.75
MSCI Emerging Markets Small Cap1.25

Source: FE Analytics, as at 21/02/2019

 

The table shows that over the short term, including small-caps has not added any additional value with returns almost entirely unchanged - despite having five extra holdings. This isn't surprising because small-cap indices have not outperformed large-cap indices over the short term, and it stresses the importance of having a long-term investment horizon if you invest in smaller companies.

However, over periods of 10 years or longer things are very different. Portfolio 2 outperforms Portfolio 1 by 42 percentage points over 10 years and 36 percentage points over 15 years. Over the long term, there are no noticeable differences in the risk levels of Portfolio 1 and Portfolio 2. Both experience the same average annual volatility, average annual drawdowns and average annual potential losses. Portfolio 2 has delivered extra return, for no more or only a bit more risk than Portfolio 1, over 10 years or more.

Andrew Herberts, head of private client investments at wealth manager Thomas Miller Investments, says there is plenty of evidence of the long-term benefits of small-cap exposure in all equity markets.

“Simpler business models, exposure to growth, innovation and liquidity premia are all factors that contribute to small-caps' long-term outperformance,” he says. “While individual smaller company share prices can be volatile, the average market outperformance is not at the cost of vastly higher risk. And this relative outperformance has been achieved in the face of two headwinds. Successful companies get promoted, so are no longer small-caps, and poorly performing companies become small-caps as their market capitalisation falls. But this strong relative outperformance is not regular and you only need to think of 2008-09 to remember that small-caps can underperform meaningfully over short time frames.”

 

Passive versus active

Smaller companies are an area where active funds are probably better because smaller companies are less researched, meaning that fund managers have better opportunities to buy the best stocks at a lower than fair price than with large-caps. Fund managers can also vet company managers, which is important, as having the right ones could make a difference to how much a company grows. Smaller companies are also more likely to fail than large-caps and passive exposure would guarantee exposure to these failures, whereas an active manager could try to avoid them. And passive exposure to small-caps means losing the winners when they get promoted to large-cap indices and buying the losers as poor companies get relegated.

Mr Herberts adds: “Passive strategies are forced to hold these, but active managers can avoid these holdings and add value.”

Another problem is that index providers have different definitions of what constitutes a small-cap, meaning that you might not have the exposure you want, depending on which index you track. For example, many investors assume that the UK's Alternative Investment Market (Aim) is a small and microcap index. But if you define microcaps as companies with market caps of less than £150m, small-caps as companies with market caps between £150m and £500m, mid-caps as companies with market caps between £500m and £4bn, and large-caps as companies with market caps greater than £4bn, the Aim index was more heavily weighted to microcaps five years ago.

"Its weighting has halved since then, while its mid-cap weighting has increased to over 40 per cent and has at times been more than 50 per cent," explains Mr Younes. "And a small-cap index significantly decreases the capacity to enhance returns, as it decreases the company-specific risk and returns.”

But Mr Herberts says there are some reasons for getting exposure to smaller companies via passive funds. For example, portfolio 2 outperforms portfolio 1 over the long term with little or no additional risk. “Most of the academic work supporting the inclusion of small-caps in a portfolio relates to index analysis, so passive exposure is a reasonable way to approach the sector,” he explains.

 

Regional balance

You also need to decide whether to invest in global or regional smaller companies funds, or an active all-cap fund whose manager can change the level of exposure to small-caps as he or she sees fit. If you have separate regional exposure you will need to hold a few funds, which means more sets of fees and more trading costs if you want to regularly rebalance your portfolio to maintain the same weightings.

With a global smaller companies fund one region’s performance, whether good or bad, can dominate overall fund returns. Active managers also tend to change geographical allocations to best suit the current environment, which can enhance returns, but it may mean they don't hold individual shares for the long term. 

Mr Herberts says all-cap fund managers tend to only hold smaller companies during short-term bull markets, so these types of funds do not benefit from long-term compounding and the effect of risk premia. This is demonstrated by some analysis conducted by Mr Younes. He found that the IA UK All Companies sector funds that outperformed the FTSE All-Share index in the first half of this decade were heavily overweight mid and small-cap companies. However, when UK smaller companies are underperforming large-caps - such as at present - all-cap fund managers might return to larger stocks to maintain their performance relative to the FTSE All-Share index. But smaller company fund managers, who are measured against different indices, would be likely to top up on discounted stocks aiding their long-term returns.

Mr Younes says that if you have a portfolio of 10 to 15 funds, you don't need a smaller companies fund for every region. He says you should rather select around two smaller company funds whose investment styles and exposures complement your existing large-cap funds.

 

Funds for smaller companies

Portfolios 1 and 2 show that having an allocation to small-caps can boost returns, and diversify portfolios over periods of 10 and 15 years. So if you cannot leave your money locked up for at least 10 years then smaller companies funds are not a good option. And an allocation to smaller companies works best when held alongside larger companies, within portfolios also diversified by sector and geography.

Mr Younes suggests getting exposure to smaller companies via Baillie Gifford Global Discovery Fund (GB0006059330), which has been managed by Douglas Brodie since 2011. The fund focuses on high-growth smaller companies, investing in stocks in sectors that are undergoing structural change or are innovation-led. This means the fund has almost 40 per cent of its assets in healthcare companies, but also holds household brands such as Ocado (OCDO). The fund is well diversified with around 100 holdings, which Mr Brodie tends to hold for the long term. On average, only a fifth of the holdings are changed each year. The fund is focused on the US, which accounts for 65 per cent of assets. The fund has beaten MSCI World Small Cap index over one, three and five years, and has an ongoing charge of 0.78 per cent.

Mr Brodie, and Baillie Gifford Global Discovery's co-managers, Svetlana Viteva and Luke Ward, also run Edinburgh Worldwide Investment Trust (EWI) via a similar strategy. Due to gearing - taking on debt to invest more than its assets - it has better long-term performance. But it is trading at a premium to net asset value (NAV) of 2 per cent.

For North American smaller companies exposure options include Artemis US Smaller Companies Fund (GB00BMMV5766). It has been run by Cormac Weldon since 2014 via a strategy he has been using since 2005, including at his previous employer Columbia Threadneedle Investments. This fund is more concentrated, with around 60 holdings, and has a fairly high turnover rate, with, on average, around half the holdings changing every year. Mr Weldon targets companies with low levels of debt that are innovating, and have the potential to substantially grow their revenues and share price over time. The fund has 25 per cent of its assets in consumer-focused stocks and 16 per cent in industrials, giving it good exposure to the US economy and consumers. Since launch in October 2014 the fund has outperformed the Russell 2000 index and the IA North American Smaller Companies sector average. It has an ongoing charge of 0.89 per cent.

For UK smaller companies exposure Mr Younes and Mr Herberts suggest Merian UK Smaller Companies Focus Fund (IE00BLP58G83). The company that runs the fund, Merian Global Investors, was until recently called Old Mutual Global Investors. Nick Williamson has been the fund's lead manager since January 2016, and was its deputy manager between 2014 and 2016. Before this he was a small-cap analyst. Since becoming lead manager he has shown great stockpicking skill, and over this period the fund has returned 64 per cent versus 22 per cent for the Numis Smaller Companies index. Mr Williamson takes very concentrated bets and the fund has greater exposure to micro-cap companies than many of its peers in the IA UK Smaller Companies sector, which has helped its relative performance. Mr Williamson is supported by Dan Nickols, who used to run this fund and is also manager of Merian UK Smaller Companies (GB00B8FD4291). Merian UK Smaller Companies Focus Fund has 66 holdings with 27.6 per cent of its assets in financial and 19.4 per cent in industrial stocks. It also holds some consumer stocks, including Boohoo (BOO) and Fevertree Drinks (FEVR). It has an ongoing charge of 0.83 per cent.

 

Table 4: Fund performance

Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)*Premium to NAV (%)**
Baillie Gifford Global Discovery17.0695.88100.130.78 
Edinburgh Worldwide Investment Trust17.18130.84112.60.812.1
IA Global sector average4.3250.359.18  
AIC Global Smaller Companies sector average4.92.218.98  
MSCI World Small Cap index4.8759.773.12  
Artemis US Smaller Companies21.290.12 0.89 
IA North American Smaller Companies sector average12.974.53   
Russell 2000 index12.0173.48   
Merian UK Smaller Companies Focus-10.1175.52 0.83 
IA UK Smaller Companies sector average-4.4536.93   
Numis Smaller Companies ex-IT index-1.7330.76   

Source: FE Analytics as at 22/02/2019, *Fund providers, **Winterflood Securities