Join our community of smart investors

The smaller companies funds taking the biggest bets

It is important to know how concentrated a fund is to assess its level of risk
The smaller companies funds taking the biggest bets
  • A fund's level of concentration has a bearing on how risky it is
  • But concentration does not necessarily make a fund more volatile
  • If funds are more diversified, characteristics such as investment style and process, sector weightings, and performance record can carry more weight

From Nick Train to the Scottish Mortgage Investment Trust (SMT) team, some of the UK’s most popular fund managers are well known for running highly concentrated portfolios. Yet not all investors have this luxury: faced with liquidity concerns and greater risks, small-cap equity managers often tend to spread their investments more thinly.

Sometimes this can lead to extremes: as we recently pointed out in the Investors’ Chronicle Ideas section (IC, 20.08.21), Herald Investment Trust (HRI), a global smaller companies trust with an appetite for tech, had more than 350 holdings at the end of June.  But this approach doesn't appear to have diminished its returns as the trust has performed well over the past decade.

High levels of diversification are not necessarily bad, but it is worth noting which funds are taking big bets and which managers are exercising caution. This can have a bearing on the risks taken, although not always in the way you might expect.


How concentrated are the UK’s small-cap winners?

Many UK smaller companies funds have delivered rich returns in the past year, but some of their managers take a much more concentrated approach than others. One indicator of concentration is the proportion of a fund's assets accounted for by their 10 largest holdings. The chart, which focuses on 15 of the best-performing open- and closed-ended funds from dedicated UK small-cap sectors over the year to 17 August, shows the different approaches taken.

On average, the funds in this selection have 27.8 per cent of assets in their top 10 holdings, but some of these take notably different approaches. Take the best performer, River & Mercantile UK Micro Cap Investment Company (RMMC), whose managers target companies with a free float of between £20m and £100m that look seriously undervalued with potential for substantial growth. Some 40 per cent of its assets were tied up in its top 10 holdings at the end of June, with just 38 holdings in the fund overall. Its top three holdings at the end of June, Sigma Capital Group (SGM), Science in Sport (SIS) and Litigation Capital Management (LIT), made up around 16 per cent of assets.

Another closed-ended fund, Odyssean Investment Trust (OIT), had just 19 holdings at the end of July and nearly 70 per cent of assets in its top 10 holdings. The largest position, in speciality chemicals company Elementis (ELM), made up more than a tenth of the trust's assets. Focusing closely on just a few names is part of its managers' process, whose strategy involves building “a concentrated portfolio of well researched quoted UK smaller companies, typically too small for inclusion in the FTSE 250”.  The Odyssean team also draws on a “lengthy and successful track record in public and private equity investing” to engage constructively with investee companies.

If you prefer a more diversified approach, plenty of strong performers in the past year have much less money tied up in their top 10 holdings, as the chart shows. Three had less than 20 per cent of their assets in their top 10 holdings, such as VT Teviot UK Smaller Companies (GB00BF6X2124), whose 10 largest holdings made up just 16.9 per cent of its assets at the end of July.

A few funds have gone all out for diversification. For example, Aberforth Smaller Companies Trust (ASL), the second strongest performer from our selection over the year to 17 August, had 27.1 per cent of its assets in its top 10 holdings and 323 holdings in total at the end of July. Marlborough Nano-Cap Growth (GB00BF2ZV048) and Henderson Smaller Companies Investment Trust (HSL), meanwhile, had 152 and 106 holdings, respectively, at the end of June.


Why does this matter to fund selection?

A fund’s level of concentration is just one of many characteristics, and Nick Train, manager of funds including Finsbury Growth & Income Trust (FGT)argued last year that focusing on a limited number of holdings can even reduce risk (IC, 22.10.20). But a fund’s level of concentration does have a bearing on how you should assess it before investing. Generally speaking, understanding and believing in the thesis for holding a fund’s top picks is more important if it is highly concentrated – especially in more controversial cases such as Baillie Gifford's enthusiasm for Tesla (US:TSLA). When funds are more diversified, characteristics such as investment style, a manager’s process, sector weightings and record can carry more weight.

Concentration is no guarantee of volatility, either. For example, Odyssean Investment Trust’s shares were down around 20 per cent between 20 February and the end of March 2020, when pandemic concerns sent markets into a tailspin. While painful for shareholders at the time, this actually made it one of the more resilient UK smaller companies funds. All the other funds listed above were down around 35 per cent or more over the same period, including Aberforth Smaller Companies, which suffered heavily despite its wide spread of holdings.

This may be heartening news if you are invested in smaller companies funds focused on other regions. The top-performing Japanese smaller companies funds over the year to 17 August include AVI Japan Opportunity Trust (AJOT) which had nearly 60 per cent of its assets in its top 10 holdings at the end of June. In the European small-cap space, Mirabaud-Discovery Europe ex-UK (LU1308314605) had 43.1 per cent of its assets in its 10 largest holdings at the end of July. By contrast, the best-performing European smaller companies fund, TR European Growth Trust (TRG), was well diversified across 135 holdings at the end of June. Recently this trust has had a focus on companies which could benefit from an economic reopening, from consumer discretionary names to the travel sector and industrial goods companies which could benefit from rising levels of capital expenditure.

Fund managers in some regions are more likely to diversify by number of holdings than others. In the US, a selection of the 10 top-performing smaller companies funds did not have substantial levels of concentration. The top performer for the year to 17 August, Legg Mason Royce US Small Cap Opportunity (IE00B23Z8V29), had a mere 7.22 per cent of assets in its top 10 holdings at the end of June and a substantial level of diversification, with 276 holdings.